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104th Congress                                              Exec. Rept.
                                 SENATE

 1st Session                                                      104-9
_______________________________________________________________________


 
        REVISED PROTOCOL AMENDING THE TAX CONVENTION WITH CANADA

                                _______


   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. 104-4, 104th Congress, 1st Session]
    The Committee on Foreign Relations, to which was referred 
the revised protocol amending the Convention between the United 
States and Canada With Respect to Taxes on Income and on 
Capital signed at Washington on September 26, 1980, as amended 
by the Protocols signed at Washington on June 14, 1983, and 
March 28, 1984 (the revised protocol was signed on March 17, 
1995), having considered the same, reports favorably thereon, 
without amendment, and recommends that the Senate give its 
advice and consent to ratification thereof, subject to one 
declaration as set forth in this report and the accompanying 
resolution of ratification.

                               I. Purpose

    The proposed revised protocol further amends the current 
treaty, as amended by the first and second protocols, and 
replaces the protocol signed on August 31, 1994. The principal 
purposes of the proposed revised protocol are to modify the 
treaty to continue to promote close economic cooperation 
between the two countries and to eliminate double taxation of 
income earned by residents of either country from sources 
within the other country, prevent evasion or avoidance of 
income taxes of the two countries and to eliminate possible 
barriers to trade caused by overlapping taxing jurisdictions of 
the two countries. It is also intended to enable the countries 
to cooperate in preventing avoidance and evasion of taxes.

                             II. Background

    The proposed revised protocol to the income tax treaty 
between the United States and Canada was signed on March 17, 
1995 (see Treaty Doc. 104-4). The proposed revised protocol 
amends the current income tax treaty between the two countries 
that was signed in 1980 and modified by protocols signed in 
1983 and 1984. The proposed revised protocol revises and 
replaces the original third protocol which was signed on August 
31, 1994, and which was pending before the Senate Committee on 
Foreign Relations at the time of its replacement.
    The proposed revised protocol was transmitted to the Senate 
for advice and consent to its ratification on April 24, 1995. 
The Senate Committee on Foreign Relations held a public hearing 
regarding the proposed revised protocol on June 13, 1995.

                              III. Summary

    Some provisions of the proposed revised protocol are 
similar to those in 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'') and from the existing treaty with Canada. 
However, the proposed revised protocol contains certain unique 
provisions as well as deviations from those models. A summary 
of the principal provisions of the proposed revised protocol, 
including some of these differences, follows:
    \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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    (1) Article 1 of the proposed revised protocol expands the 
categories of Canadian income taxes generally covered by the 
treaty to include the taxes imposed under all parts of the 
Canadian Income Tax Act, and not simply, as under the existing 
treaty, the income taxes imposed under the general income tax 
portion of the Act and under the portions addressing Canadian 
income of nonresidents and foreign corporations carrying on 
business in Canada. The proposed revised protocol expands the 
categories of U.S. taxes generally covered to include U.S. 
estate taxes, to the extent described more fully below. For 
purposes of the nondiscrimination and exchange of information 
provisions of the existing treaty, the proposed revised 
protocol expands the categories of Canadian tax covered to 
include all such taxes, not simply (as under the existing 
treaty) those imposed under the Canadian Income Tax Act. With 
these expanded provisions, the proposed revised protocol brings 
the existing treaty into closer conformity with the U.S. model 
treaty.
    The existing treaty, like other U.S. treaties, also has a 
provision addressing the applicability of the treaty to taxes 
that may be imposed by either country in the future, where 
``the future'' means any date after the treaty was signed in 
1980. The proposed revised protocol makes this provision apply 
to taxes imposed after March 17, 1995, the date that the 
proposed revised protocol was signed.
    (2) Article XXIV (Elimination of Double Taxation) 2 of 
the treaty (as it now exists and as it would be amended by the 
proposed revised protocol) uses the terms ``Canadian tax'' and 
``United States tax'' to specify those taxes deemed generally 
creditable. Under the proposed revised protocol, however, not 
all of the existing, generally covered Canadian taxes are taxes 
the United States regards as creditable income taxes. Article 2 
of the proposed revised protocol modifies the definition of 
``Canadian tax'' in Article III (General Definitions) to ensure 
that the taxes deemed creditable under the elimination of 
double taxation article of the existing treaty are only those 
generally covered Canadian taxes that are in fact taxes on 
income.
    \2\ Articles numbered by roman numeral are articles of the existing 
treaty, unless otherwise specified. Articles numbered by Arabic numeral 
are articles of the proposed revised protocol, unless otherwise 
specified.
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    The proposed revised protocol also modifies the definition 
of ``United States tax'' in Article III (General Definitions). 
The modification is intended to conform Article III to the 
protocol's rearrangement of the references to U.S. taxes in 
Article II (Covered Taxes), without changing the significance 
of the term ``United States tax'' as it is used in Article XXIV 
(Elimination of Double Taxation).
    (3) Article 3(1) of the proposed revised protocol adds 
citizenship in a treaty country to the list of factors that 
would qualify an individual for treaty benefits as a resident 
of that country. However, similar to several existing U.S. 
income tax treaties, the proposed revised protocol provides 
that a nonresident of Canada who is a U.S. citizen or green-
card holder is treated as a U.S. resident only if the 
individual has a substantial presence, permanent home, or 
habitual abode in the United States, and the individual's 
personal and economic relations are closer to the United States 
than to any third country.
    The proposed revised protocol adds language to the treaty 
to confirm the Contracting States' interpretations of the 
existing treaty, under which organizations such as governments, 
certain pension plans, and nonprofit organizations are treated 
as residents of the United States or Canada.
    Article 3(2) of the proposed revised protocol amends the 
existing treaty language under which an otherwise ``dual 
resident company'' is treated as a resident of only one country 
if it was originally created under the laws of that country. 
Under the proposed revised protocol, such a company will be 
deemed to be a resident of the other country if it is 
``continued'' in that other country. The Treasury Department's 
Technical Explanation of the Protocol Amending the Convention 
Between the United States of America and Canada with Respect to 
Taxes on Income and on Capital Signed at Washington on 
September 26, 1980, as Amended by the Protocols Signed on June 
14, 1983 and March 28, 1984 (``Technical Explanation'') 
indicates that the term ``continuation'' under Canadian law 
refers to the local incorporation of an entity that is already 
organized and incorporated under the laws of another country.
    (4) Like some other U.S. treaties (such as those with 
Mexico and Finland), but unlike the OECD and U.S. models, the 
existing treaty allows each country to impose a time limit on 
taxpayer claims for refund or other adjustments that arise from 
(and hence ``correlate'' to) adjustments previously imposed on 
a related person by the tax authorities of the other country. 
The time limit under the existing treaty allows the first 
country to reject the claim for a correlative adjustment if its 
tax authority was not notified of the other country's 
adjustment within 6 years from the end of the taxable year to 
which the adjustment relates. Furthermore, if the notification 
is not timely and the taxpayer was not notified by the other 
country of the adjustment at least 6 months prior to the end of 
the 6-year period, then (absent fraud, willful default or 
neglect, or gross negligence) the existing treaty requires the 
other country to refrain from making its adjustment to the 
extent that the adjustment would give rise to double taxation.
    Article 4 of the proposed revised protocol allows the 
competent authorities to agree that the first country may waive 
the 6-year notification requirement if the correlative 
adjustment would not otherwise be barred by its own time or 
procedural limitations. In addition, the proposed revised 
protocol eliminates the obligation of the other country to 
refrain from making its original adjustment, and instead simply 
permits the competent authority to provide relief from double 
taxation ``where appropriate.''
    (5) Article 5 of the proposed revised protocol generally 
lowers the existing treaty's 10-percent tax rate on direct 
investment dividends (i.e., dividends paid to companies 
resident in the other country that own directly at least 10 
percent of the voting stock of the payor) and branch profits 
taxes. The lower rate under the proposed revised protocol is 7 
percent in 1995, 6 percent in 1996, and 5 percent (as in the 
U.S. model treaty and numerous other U.S. treaties) thereafter.
    Canada provides special tax benefits to so-called ``non-
resident-owned investment corporations.'' Such a corporation is 
subject to a lower rate of statutory income tax than the 
general corporate rate (25 percent vs. 38 percent), and is 
exempt from tax on non-Canadian capital gains. Under Article 
5(2) of the proposed revised protocol, Canada is permitted to 
impose the existing 10-percent rate, rather than the lowered 
rate, on a direct investment dividend paid to a U.S. resident 
by a non-resident-owned investment corporation.
    As under other U.S. treaty provisions adopted since 1988, 
the proposed revised protocol permits the United States to 
impose tax at the rate applicable to ``portfolio dividends'' 
(i.e., dividends other than direct investment dividends), in 
the case of any dividend from a regulated investment company (a 
``RIC'') or real estate investment trust (a ``REIT''). Under 
the existing treaty, the portfolio dividend tax rate is 15 
percent and generally is not altered by the proposed revised 
protocol. However, the proposed revised protocol provides that 
the general limitation on taxation of portfolio dividends does 
not apply to a dividend paid by a REIT, except for a dividend 
that is beneficially owned by an individual holding an interest 
of less than 10 percent in the REIT (treating as an individual 
any estate or testamentary trust that acquired its interest in 
the REIT as a consequence of an individual's death within the 
previous 5 years).
    (6) Article 6(1) of the proposed revised protocol lowers to 
10 percent the existing treaty's generally applicable 15-
percent limit on source-country taxation of interest. Article 
6(2) of the proposed revised protocol broadens the existing 
exemption from source country withholding in the case of the 
sale of equipment, merchandise or services on credit. Article 
6(3) of the proposed revised protocol conforms to U.S. internal 
law that requires 30-percent withholding on an excess inclusion 
of a foreign person with respect to a residual interest in a 
real estate mortgage investment conduit (a ``REMIC''), without 
reduction under the treaty.
    (7) The existing treaty contains a 2-tier limitation on 
source-country taxation of royalties. Only the residence 
country may tax royalties and similar payments in respect of 
the production or reproduction of literary, dramatic, musical 
or artistic work, if such payments are not in respect of motion 
pictures or works for use in connection with television. 
Royalties that do not qualify for the exemption may be taxed by 
the source country at a rate not to exceed 10 percent. Article 
7(1) of the proposed revised protocol expands the class of 
payments that qualify for the exemption to include payments for 
the use of, or the right to use, patents and information 
(unless provided in connection with a rental or franchise 
agreement) concerning industrial, commercial or scientific 
experience, and clarifies that computer software royalties are 
also included in the exempt class. The proposed revised 
protocol permits the treaty countries to agree to add 
additional payments to the exempt category (by an exchange of 
diplomatic notes without additional treaty ratification 
procedures), if they are payments with respect to broadcasting.
    The existing treaty includes a source rule for royalties 
that, similar to U.S. internal law, sources royalties primarily 
by place of use. Article 7(2) of the proposed revised protocol, 
by contrast, introduces a new source rule under which the 
royalties are sourced primarily by reference to the residence 
of the payor or the location of a permanent establishment or 
fixed base of the payor.
    (8) To the extent that the existing treaty provides the 
competent authority of one country the discretion to defer the 
recognition of the gain or other income on the alienation of 
property in the course of a corporate organization, 
reorganization, amalgamation, division or similar transaction, 
Article 8 of the proposed revised protocol provides similar 
discretion in the case of a comparable transaction involving 
noncorporate entities. One practical effect of this change is 
explicitly to authorize the exercise of discretion in the case 
of a reorganization of a Canadian mutual fund organized as a 
trust.
    (9) The existing treaty has a provision limiting source-
country taxation of pensions. Article 9(1) of the proposed 
revised protocol makes a slight change in the definition of the 
term ``pensions.'' The protocol clarifies that the definition 
of pensions includes, for example, payments from a U.S. 
individual retirement account (an ``IRA''), and provides that 
the definition of pension includes, for example, payments from 
a Canadian registered retirement savings plan (a ``RRSP'') or 
registered retirement income fund (a ``RRIF'').
    The existing treaty has provisions giving sole taxing 
jurisdiction over social security benefits to the residence 
country (if paid by the other country), and limiting the taxing 
jurisdiction of the United States over Canadian social security 
benefits received by a Canadian resident who is a U.S. citizen. 
Article 9(2) of the proposed revised protocol, like most other 
treaties negotiated since the Social Security Amendments of 
1983, eliminates those provisions and gives sole taxing 
jurisdiction to the source country.
    In addition, under present law, certain Canadian retirement 
plans that are qualified plans for Canadian tax purposes do not 
meet U.S. internal law requirements of qualification. The 
existing treaty, however, permits a U.S. taxpayer who is a 
beneficiary of an RRSP to obtain U.S. tax deferral 
corresponding to the deferral that the RRSP provides under 
Canadian tax law, to the extent that income is reasonably 
attributable to contributions made to the plan by the 
beneficiary while he was a Canadian resident (see Rev. Proc. 
89-45, 1989-2 C.B. 872). The proposed revised protocol expands 
the class of retirement or other employee benefit arrangements 
favored by Canadian law with respect to which the United States 
will grant corresponding deferral of U.S. tax, and confirms 
that Canada will provide reciprocal treatment to a Canadian 
taxpayer who is a beneficiary under a pension plan or other 
arrangement that qualifies for deferral of U.S. tax under U.S. 
law.
    (10) The existing treaty provides that each country 
generally exempts dividends and interest from source-country 
taxation when earned by a trust, company, or other organization 
constituted and operated exclusively in connection with certain 
employee benefits, such as pensions. Article 10(1) of the 
proposed revised protocol modifies the provision to exempt 
dividends and interest from source-country income taxation, and 
modifies the description of the payees that are exempted under 
this provision to refer to a trust, company, organization, or 
other arrangement, generally exempt from income tax, and 
operated exclusively to administer or provide employee 
benefits. This is intended to clarify that IRAs, RRSPs, and 
RRIFs, for example, are intended to benefit from the provision.
    The existing treaty provides that a U.S. resident may take 
a U.S. tax deduction for a charitable contribution to a 
Canadian organization that could qualify to receive deductible 
contributions if it were itself a U.S. resident. Article 10(2) 
of the proposed revised protocol extends this benefit to a 
Canadian corporation that is taxed by the United States as a 
U.S. corporation under internal U.S. law (e.g., by virtue of an 
election under Code section 1504(d)).
    The existing treaty provides that a Canadian resident must 
be allowed a Canadian tax deduction for a gift to a U.S. 
organization that could qualify to receive deductible gifts if 
it were itself created or established and resident in Canada. 
Canadian law was changed, since the existing treaty was last 
amended, to provide a credit, rather than a deduction, for 
certain gifts. The proposed revised protocol confirms that 
Canada is required to provide the appropriate relief--that is, 
deduction or credit--where a gift is made by a Canadian 
resident to a U.S. organization that could qualify in Canada as 
a registered charity, were it created or established and 
resident in Canada.
    (11) A nonresident alien individual or foreign corporation 
generally is subject to U.S. tax on gross U.S. source gambling 
winnings, collected by withholding. In general, no offsets or 
refunds are allowed for gambling losses (Barba v. United 
States, 2 Cl. Ct. 674 (1983)). On the other hand, a U.S. 
citizen, resident, or corporation may be entitled to deduct 
gambling losses to the extent of gambling winnings (sec. 
165(d)). In Canada, an individual is subject to tax on income 
derived from gambling only if the gambling activities 
constitute carrying on a trade or business (e.g., the 
activities of a bookmaker). Whether gambling activities rise to 
the level of a trade or business is determined on the facts and 
circumstances of each case.
    Article 11 of the proposed revised protocol adds a 
provision not found in any other U.S. treaty or the model 
treaties, under which the United States must allow a Canadian 
resident to file a refund claim for U.S. tax withheld, to the 
extent that the tax would be reduced by deductions for U.S. 
gambling losses the Canadian resident incurred under the 
deduction rules that apply to U.S. residents.
    (12) Under internal law allowing a credit for foreign 
income tax, the United States has in the past provided a credit 
for Canada's social security tax (Rev. Rul. 67-328, 1962-2 C.B. 
257). Article 12(1) of the proposed revised protocol obligates 
Canada to give a foreign tax credit for U.S. social security 
taxes paid by individuals (other than taxes relating to 
unemployment insurance benefits). This rule may have great 
significance in the case of Canadian residents who commute 
across the border to employment in the United States.
    The proposed revised protocol makes a number of changes to 
the article requiring the United States and Canada to provide 
credits for taxes imposed by the other country or (in Canada's 
case) corporate tax exemptions for income from U.S. affiliates, 
generally prompted by changes to U.S. and Canadian internal law 
since the last amendments to the existing treaty were adopted. 
The proposed revised protocol clarifies, for example, that even 
where the treaty exempts income or capital from taxation in a 
particular country, that country is nevertheless entitled to 
take the exempt income or capital into account for purposes of 
computing the tax on other income or capital.
    (13) The existing treaty provides that in computing taxable 
income, a treaty country must permit a resident to take a 
deduction for a dependent resident in the other country to the 
same extent that would be allowed if the dependent resided in 
the first country. Since the last amendment to the treaty was 
adopted, the Canadian law dependent deduction was converted to 
a dependent credit; that is, a deduction in computing tax, as 
opposed to taxable income. Article 13(1) of the proposed 
revised protocol confirms that each country is required provide 
the appropriate deduction--whether from taxable income or 
simply from tax--for a dependent residing in the other country.
    Article 13(2) of the proposed revised protocol expands the 
categories of Canadian taxes covered by the nondiscrimination 
article to include all taxes, including for example excise and 
goods and services taxes, rather than only (as under the 
existing treaty) those imposed under the Income Tax Act. 
Extension of the nondiscrimination rule to all taxes imposed by 
a treaty country will also apply to the United States under the 
proposed revised protocol, although this is in general already 
true under the existing treaty, because the existing article 
applies to all taxes imposed under the Internal Revenue Code 
(the ``Code'').
    (14) Like the U.S. treaties with Germany, the Netherlands, 
and Mexico, Article 14(2) of the proposed revised protocol 
provides for a binding arbitration procedure to be used to 
settle disagreements between the two countries regarding the 
interpretation or application of the treaty. The arbitration 
procedure can only be invoked by the agreement of both 
countries. As is true under the treaties with the Netherlands 
and Mexico, the effective date of this provision is delayed 
until the two countries have agreed that it will take effect, 
to be evidenced by a future exchange of diplomatic notes.
    (15) Article 15 of the proposed revised protocol adds a 
treaty provision requiring each country to undertake to lend 
administrative assistance to the other in collecting taxes 
covered by the treaty. The assistance provision is 
substantially broader than the corresponding provisions in the 
U.S. model treaty and the existing treaty. Although collection 
assistance provisions like that in the proposed revised 
protocol appear in the U.S. treaty with the Netherlands, and to 
some extent in the present (and proposed) treaties with France 
and Sweden, entry into a provision such as the one in the 
proposed revised protocol, with a country that presently has no 
similar provision in a treaty with the United States, is a 
departure from U.S. treaty policy of recent years.
    (16) In a departure from the model treaties and other U.S. 
treaties, Article 16 of the proposed revised protocol entitles 
either treaty country to share information it received from the 
other country with persons or authorities involved in the 
assessment, collection, administration, enforcement, or 
appeals, of state, provincial, or local taxes substantially 
similar to the taxes covered generally by the treaty as amended 
by the proposed revised protocol. This change is in some ways 
similar to, although significantly narrower than, the proposed 
additional protocol with Mexico.
    The proposed revised protocol expands the categories of 
Canadian taxes covered by the exchange of information article 
to include all taxes, including excise and goods and services 
taxes, rather than (as under the existing treaty) only those 
imposed under the Income Tax Act. As is true in the case of the 
nondiscrimination article, application of the exchange of 
information article to all taxes imposed by a treaty country 
also applies to the United States under the proposed revised 
protocol, although this is in general already true under the 
existing treaty, because the existing article applies to all 
taxes imposed under the Code.
    (17) Article 17 of the proposed revised protocol modifies 
the provision of the existing treaty relating to miscellaneous 
rules.
    Under U.S. and Canadian internal law, corporate earnings 
generally are taxed to shareholders only upon distribution. 
However, a limited class of U.S. small business corporations 
may elect, under subchapter S of the Code, to have their income 
taken into account by their shareholders, rather than 
themselves (whether or not the income is distributed), and to 
exempt from tax their distributions of earnings. In some cases 
it may be possible for a Canadian resident to be a shareholder 
in a so-called ``S corporation.'' Article 17(2) of the proposed 
revised protocol adds a new provision under which the Canadian 
tax authorities may agree to impose Canadian income tax on the 
shareholder using essentially the same timing rules as the U.S. 
S corporation rules, providing foreign tax credits for the U.S. 
tax imposed under those rules.
    The multilateral trade agreements encompassed in the 
Uruguay Round Final Act, which entered into force as of January 
1, 1995, include a General Agreement on Trade in Services 
(``GATS''). This agreement obligates members (such as the 
United States and Canada) 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. If members 
disagree as to whether a measure falls within the scope of a 
tax treaty, or if a member considers that another member 
violates its GATS obligations, then the GATS provides that 
members will resolve their issues under procedures set up under 
GATS, with one exception. Disagreements whether a measure falls 
within the scope of a tax treaty existing on the date of entry 
into force of the proposed Agreement Establishing the World 
Trade Organization (January 1, 1995) may be subject to GATS 
procedures only with the consent of both parties to the tax 
treaty.
    Article 17 of the proposed revised protocol specifies that 
for this purpose, a measure falls within the scope of the 
existing treaty (as modified by the proposed revised protocol) 
if it relates to any tax imposed by Canada or the United 
States, or to any other tax to which any part of the treaty 
applies (e.g., a state, provincial, or local tax), but only to 
the extent that the measure relates to a matter dealt with in 
the treaty. Moreover, any doubt about the interpretation of 
this scope is to be resolved between the competent authorities 
as in any other case of difficulty or doubt arising as to the 
interpretation or application of the treaty, or under any other 
procedures agreed to by the two countries, rather than under 
the procedures of the GATS.
    The proposed revised protocol contains a provision that 
requires the appropriate authorities to consult on appropriate 
future changes to the treaty whenever the internal law of one 
of the treaty countries is changed in a way that unilaterally 
removes or significantly limits any material benefit otherwise 
provided under the treaty. This provision corresponds to 
provisions in U.S. treaties with the Netherlands, Mexico, and 
Israel that contemplate further negotiations in the event of 
relevant changes to internal law.
    (18) Article 18 of the proposed revised protocol contains a 
limitation on benefits, or ``anti-treaty-shopping'' article 
that permits the United States to deny treaty benefits to a 
resident of Canada unless requirements, similar in many 
respects to those contained in recent U.S. treaties and in the 
branch tax provisions of the Code, are met. This provision 
replaces very limited anti-abuse provisions denying benefits 
under the existing treaty. The proposed revised protocol 
includes a derivative benefits provision. It is similar in some 
respects to, and different in other respects from, the 
derivative benefits provisions in the anti-treaty-shopping 
articles of the Netherlands and Mexico treaties. Unlike most 
other corresponding U.S. treaty provisions, the proposed anti-
treaty-shopping article does not entitle Canada to deny any 
treaty benefits. The proposed revised protocol indicates, and 
the Technical Explanation clarifies, that both countries may 
deny benefits under otherwise applicable anti-abuse principles.
    (19) Canada does not impose an estate tax. For Canadian 
income tax purposes, however, capital assets of a decedent are 
deemed to have been disposed of immediately before death. Thus, 
gains inherent in capital assets held at death generally are 
subject to Canadian income tax. Article 19 of the proposed 
revised protocol is intended to coordinate the U.S. estate tax 
with the Canadian income tax upon gains deemed realized at 
death.
    The estate tax coordination rules apply to residents of the 
United States and of Canada as defined in the existing treaty 
(as modified by the protocol, as noted above). The treaty's 
residence rules are somewhat different from the residence rules 
that apply for estate tax purposes under the Code or under most 
U.S. estate tax treaties.
    The proposed revised protocol obligates Canada and the 
United States to treat a decedent's bequest to a religious, 
scientific, literary, educational, or charitable organization 
resident in the other country in the same manner as if the 
organization were a resident of the first country. Thus, for 
U.S. estate tax purposes, a deduction generally is allowed for 
a bequest by a Canadian resident to a qualifying exempt 
organization resident in Canada, provided the property 
constituting the bequest is subject to U.S. estate tax.
    In general, U.S. citizens and residents are allowed a 
unified credit of $192,800 against their cumulative lifetime 
U.S. estate and gift tax liability. Nonresident aliens 
generally are allowed a credit of $13,000 against the U.S. 
estate tax. For U.S. estate tax purposes, the proposed revised 
protocol generally provides Canadian residents who are not 
United States citizens with a pro rata portion of the unified 
credit allowed to U.S. citizens and residents. 3 The pro 
rata portion is based upon the ratio that the Canadian 
resident's gross estate situated in the United States bears to 
his worldwide gross estate. This credit must be reduced for any 
gift tax unified credit previously allowed for any gift made by 
the decedent. Also, the credit may not exceed the U.S. estate 
tax imposed on the decedent's estate. Allowance of the pro rata 
unified credit is conditioned upon the taxpayer providing 
sufficient documentation to verify the amount of the credit.
    \3\  The credit allowed to a Canadian resident would be not less 
than $13,000.
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    Since enactment of the Technical and Miscellaneous Revenue 
Act of 1988 (``TAMRA''), the general 100-percent marital 
deduction from the U.S. estate and gift tax has been 
substantially limited in the case of property passing to a 
noncitizen spouse. The proposed revised protocol allows an 
estate to elect a limited estate tax marital credit for 
property that would qualify for the marital deduction if the 
surviving spouse had been a U.S. citizen, provided the 
following conditions are met: (1) the surviving spouse is a 
resident of one of the treaty countries, (2) the decedent 
spouse was a U.S. citizen or a resident of one of the treaty 
countries, (3) where both spouses are U.S. residents, at least 
one spouse is a citizen of Canada, and (4) the executor of the 
decedent's estate irrevocably waives any estate tax marital 
deduction that may be allowed under the Code. In general, the 
credit is the lesser of the decedent's unified credit (allowed 
under the proposed revised protocol or under U.S. domestic 
law), or the estate tax that would otherwise be imposed on the 
marital transfer.
    The United States by statute allows a foreign tax credit 
against U.S. estate tax for foreign estate, inheritance, legacy 
or succession taxes (sec. 2014). Imposition of the Canadian 
income tax on deemed dispositions at death is not at present 
creditable under Code section 2014 (Rev. Rul. 82-82, 82-1 C.B. 
127). \4\ Under the proposed revised protocol, the estate of a 
U.S. citizen or resident (or the estate of a surviving spouse 
with respect to a qualified domestic trust) would receive a 
U.S. estate tax credit for the Canadian Federal and provincial 
income taxes imposed at the decedent's death with respect to 
property situated outside of the United States. The credit is 
limited to the amount of U.S. estate tax that is imposed on the 
decedent's estate situated outside the United States. Also, no 
credit against U.S. estate tax generally may be claimed to the 
extent that a credit or deduction for the Canadian tax is 
claimed against U.S. income tax.
    \4\ The United States by statute also allows a foreign tax credit 
against U.S. income tax for foreign income taxes (sec. 901). The 
Canadian income tax on deemed dispositions at death generally is 
creditable under Code section 901.
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    Under the U.S. model estate and gift tax treaty, the United 
States exempts the estate of a decedent domiciled in the other 
country from U.S. estate tax, except to the extent that the 
decedent's estate consists of real property situated in the 
United States or assets that are part of the business property 
of a permanent establishment or fixed base in the United 
States. The proposed revised protocol extends this treatment to 
the estate of a Canadian resident (who is not a citizen of the 
United States), but only if the value of the decedent's 
worldwide gross estate does not exceed $1.2 million.
    The Canadian income tax on gain from the deemed disposition 
of property of a decedent may be deferred if the property 
passes to the surviving spouse or a ``spousal trust,'' provided 
that both the decedent and the surviving spouse (or the spousal 
trust, as applicable) were residents of Canada immediately 
before the decedent's death. The proposed revised protocol 
exempts from the gains at death tax deathtime transfers to a 
surviving spouse where the decedent was a resident of the 
United States immediately before death. Also, under the 
proposed revised protocol, the Canadian competent authority may 
agree to treat a qualified domestic trust for U.S. estate tax 
purposes as a ``spousal trust'' for Canadian tax purposes. 
Thus, the proposed revised protocol enables a transfer to a 
trust on behalf of a non-U.S. citizen spouse to qualify 
simultaneously for the U.S. estate tax marital deduction and 
for deferral of the Canadian income tax on gains deemed 
realized at death.
    Canada, like the United States, generally gives a foreign 
tax credit against the income tax only for foreign income tax. 
The proposed revised protocol requires Canada to give a 
Canadian resident decedent (and a Canadian resident spousal 
trust) a limited income tax credit for certain U.S. estate and 
inheritance taxes. The credit generally is limited to the 
amount of Canadian income tax (after reduction by credit for 
U.S. income tax) that is imposed on income that the United 
States is entitled (without regard to the saving clause) to 
subject to estate tax under the treaty. If the decedent is 
subject to U.S. estate tax on property other than that situated 
in the United States, the amount of U.S. estate tax that Canada 
must credit against income tax is limited to that portion of 
the U.S. tax imposed on U.S.-situs property.
    (20) Article 20 of the proposed revised protocol requires 
the appropriate authorities of Canada and the United States to 
consult within 3 years with respect to further reductions in 
withholding taxes, and with respect to the limitation on 
benefit rules. They are to consult after 3 years also to 
determine whether to make the arbitration provision effective 
through an exchange of diplomatic notes.

                          IV. Entry Into Force

    The proposed revised protocol will enter into force upon 
the exchange of instruments of ratification.
    With respect to taxes withheld at source on dividends, 
interest, royalties and pensions and annuities (other than 
social security benefits), the proposed treaty will be 
effective with respect to amounts paid or credited on or after 
the first day of the second month after the protocol enters 
into force. A phase-down of the withholding rate applies with 
respect to certain dividends (if the beneficial owner is a 
company, other than a partnership, that holds directly at least 
10 percent of the paying company's capital). Under the phase-
down, the rate after the above general effective date and 
before 1996 will be 7 percent, and the rate after 1995 and 
before 1997 will be 6 percent. Thereafter the rate will be 5 
percent.
    With respect to other taxes, the proposed revised protocol 
generally is to be effective for taxable years beginning on or 
after the first day of January after the protocol enters into 
force. A different phase-down of the rate will apply to amounts 
taxed under Article X, paragraph 6 of the existing treaty 
(relating to the branch tax, as amended by the protocol); under 
this phase-down, the applicable rate will be 6 percent for 
taxable years beginning after the general effective date 
(above) and ending before 1997, and 5 percent thereafter.
    The provision relating to assistance in collection (Article 
15 of the proposed revised protocol) will be effective for 
revenue claims finally determined after the date that is 10 
years before the date on which the proposed revised protocol 
enters into force.
    Provisions relating to taxes imposed by reason of death 
(Article 19 of the proposed revised protocol, other than 
paragraph 1 of Article 19 (relating to property passing to an 
exempt organization by reason of an individual's death), and 
certain related provisions) generally will be effective with 
respect to deaths occurring after the date on which the 
proposed revised protocol enters into force. If a claim for 
refund is filed within one year after the date on which the 
proposed revised protocol enters into force, or within the 
otherwise applicable period for filing such claims under 
domestic law, then these provisions will be effective with 
respect to deaths occurring after November 10, 1988, 
notwithstanding any limitation under internal Canadian or U.S. 
law on the assessment, reassessment or refund with respect to a 
person's return.
                          V. Committee Action

    The Committee on Foreign Relations held a public hearing on 
the proposed revised protocol to the income tax treaty between 
the United States and Canada, and on other proposed tax 
treaties and protocols, on June 13, 1995. The hearing was 
chaired by Senator Thompson. The Committee considered the 
proposed revised protocol to the income tax treaty between the 
United States and Canada on July 11, 1995, and ordered the 
proposed revised protocol favorably reported by a voice vote, 
with the recommendation that the Senate give its advice and 
consent to the ratification of the proposed revised protocol 
with the declaration described below.

                         VI. Committee Comments

    The Committee on Foreign Relations approved the proposed 
revised protocol with a declaration regarding the exchange of 
notes on the treatment of broadcasting royalties under the 
proposed revised protocol. The Committee believes that the 
proposed revised protocol is in the interest of the United 
States and urges that the Senate act promptly to give its 
advice and consent to ratification. The Committee has taken 
note of certain other issues raised by the proposed revised 
protocol, 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. Taxes Imposed by Reason of Death

In general

    Until 1972, Canada had a succession duty. At that time, 
Canada instituted a system under which, instead of imposing an 
estate tax, capital property of a decedent is deemed, for 
income tax purposes, to have been disposed of immediately 
before death. Thus, any gains inherent in capital assets held 
at death generally are subject to Canadian income tax (the 
``gains at death tax'').\5\
    \5\ With respect to certain transfers to spouses or ``spousal 
trusts,'' no tax is imposed because the amount deemed realized is the 
decedent's basis in the property; the spouse or spousal trust obtains a 
carryover basis.
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    The United States and Canada previously have been parties 
to bilateral estate tax treaties, the last of which was 
terminated effective in 1985. Article 19 of the proposed 
revised protocol adds a new Article XXIX B to the existing 
treaty. The new Article XXIX B once again provides in certain 
cases for the reduction of U.S. estate tax on the estate of a 
decedent who is a resident of Canada; it would also in certain 
cases provide for the reduction of the Canadian income tax on 
gains deemed realized at death with respect to the estate of a 
person that is liable for U.S. estate tax.
    A principal purpose of the proposed revised protocol is to 
coordinate the U.S. estate tax with the Canadian gains at death 
tax. In this respect, the proposed revised protocol is unique; 
it is the first time the United States has entered into a tax 
treaty covering estate taxes with a country that does not 
impose an estate or inheritance tax. The Committee believes 
that the unique coordination of the two death tax regimes is 
warranted, given the special relationship between the United 
States and Canada. The Committee wishes to stress, however, 
that the coordination of the two death tax regimes under the 
proposed revised protocol should not be viewed as a precedent 
in future treaty negotiations with other countries that do not 
impose estate or inheritance taxes. In this connection, at the 
hearing the Committee queried the Treasury Department and 
received the following response by letter to Senator Thompson 
dated July 5, 1995:\6\
    \6\ 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 letter'').

          2. Is the coordination of [the U.S. estate tax and 
        the Canadian gains at death tax] necessary? If so, are 
        the concessions granted by the U.S. appropriate to 
        achieve coordination?
          We believe that coordination of the U.S. and Canadian 
        death tax regimes is necessary and that the Protocol 
        accomplishes this coordination in an appropriate 
        manner. Like the United States, Canada imposes a 
        substantial tax at death. In many cases, both the U.S. 
        and the Canadian death taxes apply to a particular 
        transfer of property at death. This can result in 
        double taxation at a combined tax rate of more than 75 
        percent, even where the property is transferred to a 
        surviving spouse. The laws of the two countries do not 
        relieve such double taxation because the Canadian death 
        tax is structured as an income tax at death, while the 
        United States imposes an estate tax. Treaty relief is, 
        therefore, necessary.
          The death tax provisions of the Protocol are narrowly 
        targeted and are drafted reciprocally where necessary. 
        Each country agrees to allow an appropriate credit for 
        the death taxes imposed in the other country. The pro 
        rata unified credit and marital credit allowed by the 
        United States are limited in amount and linked to the 
        estate tax exposure of the particular case. In return, 
        Canada agreed to allow unlimited deferral for transfers 
        to surviving spouses and, in appropriate cases, for 
        transfers to spousal trusts. The limited waiver of U.S. 
        estate tax on certain types of property provides some 
        reciprocity to Canada and is consistent with provisions 
        in U.S. estate tax treaties; Canada already waives its 
        death tax, without limitation, on the same types of 
        property under the current treaty.
          A comprehensive tax treaty cannot be evaluated based 
        on only one of its provisions. However, the substantial 
        benefits that this provision will provide to residents 
        of both countries represent an important factor 
        weighing in favor of approval of this Protocol.
Charitable bequests

    Under paragraph 1 of new Article XXIX B, a charitable 
bequest by a resident of either the United States or Canada to 
a qualifying exempt organization of the other country is 
treated as if the exempt organization were a resident of the 
first country. A similar provision already exists for income 
tax purposes under Article XXI of the existing treaty between 
the United States and Canada. Thus, although this provision 
appears on its face to grant reciprocal benefits, it is in 
effect only a concession by the United States to allow a U.S. 
estate tax deduction for charitable bequests by a Canadian 
resident to a qualifying Canadian resident organization.7 
Charitable bequests by Canadian residents to qualifying U.S. 
resident organizations already are deductible from the Canadian 
gains at death tax under the terms of the existing treaty.
    \7\ Under Code section 2055, charitable bequests by a U.S. citizen 
or resident to a qualifying Canadian resident organization are 
deductible for U.S. estate tax purposes in determining the decedent's 
taxable estate.
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    It is anticipated that the determination of an 
organization's exempt status for purposes of this charitable 
bequest provision is made in the same manner as under the 
provisions of Article XXI of the existing treaty for income tax 
purposes.

Pro rata unified credit

    In TAMRA, Congress passed Code section 2102(c)(3) which 
permits a ``pro rata'' unified credit for nonresidents to the 
extent provided by treaty. The pro rata unified credit equals 
the unified credit allowed to U.S. citizens and residents, 
multiplied by the fraction of the total worldwide gross estate 
situated in the United States. Paragraph 2 of new Article XXIX 
B provides such a pro rata unified credit to Canadian residents 
who are not U.S. citizens.8
    \8\ The saving clause of the proposed revised protocol preserves 
the ability of the United States to reduce the unified credit allowable 
to $13,000 under Code section 2107 with respect to citizens who have 
expatriated to Canada within the past ten years.
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    This is the first time that a pro rata unified credit has 
been granted under a treaty with a treaty partner that does not 
itself impose an estate or inheritance tax. The Committee 
believes that the special relationship between Canada and the 
United States warrants the grant of the pro rata unified credit 
to Canadian residents who are not U.S. citizens. The Committee 
wishes to stress that this treatment should not be viewed as a 
precedent in future treaty negotiations with other countries 
that do not impose an estate or inheritance tax.
    Under the proposed revised protocol, assets exempted from 
the estate tax under the Canadian treaty (e.g., under paragraph 
8 of new Article XXIX B) arguably are treated as ``situated in 
the United States'' and thus are still taken into account in 
the numerator for purposes of computing the pro rata unified 
credit. A proposed technical correction to Code section 
2102(c)(3) that is currently under consideration by the 
Congress would clarify that, in determining the pro rata 
unified credit under a treaty, property exempted by the treaty 
from U.S. estate tax would not be treated as situated in the 
United States.9 The Committee wishes to clarify its 
understanding that the question of whether property is situated 
in the United States for purposes of this provision of the 
proposed revised protocol is determined under U.S. domestic 
law. Thus, the Committee intends and believes that, if the 
proposed technical correction is adopted, property exempted by 
the Canadian treaty would not be treated as situated in the 
United States and therefore would be excluded from the 
numerator for purposes of computing the pro rata unified credit 
under the proposed revised protocol.
    \9\ H.R. 1215, as passed by the House, 104th Cong., 1st Sess. 
(1995), section 604(f)(1) (1995).
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Estate tax marital credit for Canadian residents

    To determine the taxable estate of a decedent for U.S. 
estate tax purposes, a deduction generally is allowed for the 
value of any property that passes to his or her surviving 
spouse. TAMRA, however, eliminated this marital deduction where 
the surviving spouse is not a U.S. citizen (except for 
transfers to a ``qualified domestic trust'' (``QDOT'') 10 
or where the surviving spouse becomes a U.S. citizen). Several 
countries have sought U.S. treaty relief from this TAMRA 
provision, including some countries with pre-TAMRA U.S. estate 
tax treaties that have provisions relating to the marital 
deduction. The proposed revised protocol contains the first 
agreement by the United States to provide such relief. The 
Committee believes that the granting of the marital deduction 
in the proposed revised protocol is appropriate in part because 
of the special relationship between the United States and 
Canada, and should not necessarily be viewed as a precedent by 
other countries seeking similar relief.
    \10\ A trust may qualify as a QDOT if it has at least one trustee 
that is a U.S. citizen or a domestic corporation and if no 
distributions of corpus can be made unless the U.S. trustee may 
withhold the tax from those distributions. Code section 2056A.
    Under the proposed revised protocol, Paragraphs 3 and 4 of 
new Article XXIX B provide a marital credit against the U.S. 
estate tax on property passing to a noncitizen spouse if the 
decedent and the surviving spouse meet certain requirements 
regarding residency and citizenship. In addition, the credit is 
available only if the executor of the decedent's estate 
irrevocably waives the benefits of any estate tax marital 
deduction that may otherwise be allowed.
    The credit allowed under the treaty equals the lesser of 
(1) the same amount as the pro rata unified credit allowable 
under the proposed revised protocol or under U.S. domestic law, 
and (2) the amount of the U.S. estate tax that would otherwise 
be imposed on the qualifying property transferred to the 
spouse. The marital credit is in addition to any amount 
exempted by the unified credit. Thus, the marital credit 
effectively grants couples covered by the treaty a 
proportionate share (based on the portion of their gross estate 
situated in the U.S.) of the same aggregate $1.2 million estate 
tax exemption allowed to U.S. citizen couples.11 This 
provision is similar to the approach taken in recent proposed 
legislation to grant a limited marital transfer credit to 
employees of ``qualified international organizations.'' (See, 
for example, H.R. 1401, 104th Cong., 1st Sess. (1995).) The 
credit amount also generally is sufficient to resolve a 
principal area of concern--the reduction of the estate tax 
burden on transfers of personal residences and retirement 
annuities.
    \11\ Because of the graduated estate tax rate structure, full 
availability and use of both credits will never completely shelter the 
U.S. estate tax on a $1.2 million gross estate. See example 2 of the 
Technical Explanation.
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Treatment of certain transfers to spouses

    For purposes of the Canadian gains at death tax, Canada 
grants an exemption for transfers to surviving spouses and 
``spousal trusts,'' provided that both the decedent and the 
spouse (or the spousal trust, as applicable) were residents of 
Canada immediately before the decedent's death. Thus, under 
present Canadian law, a transfer from a Canadian resident 
decedent to a U.S. resident spouse or from a U.S. resident 
decedent to a Canadian resident spouse does not qualify for the 
marital exemption.12 Under the proposed revised protocol, 
Paragraph 5 of new Article XXIX B exempts from the gains at 
death tax deathtime transfers to a spouse where the decedent 
was a resident of the United States immediately before death. 
Thus, transfers from a U.S. resident decedent to a Canadian 
resident spouse (or for that matter a spouse with any 
residence) qualifies for exemption. The converse, however, is 
not true--a transfer from a Canadian resident decedent to a 
U.S. resident spouse does not qualify for exemption.
    \12\ Nonresidents generally are subject to the gains at death tax 
on certain Canadian situs property.
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    Under Canadian domestic law, a spousal trust is treated as 
resident in Canada if the trustee is a Canadian resident or a 
Canadian corporation. Upon request by a U.S. resident trust, 
the Canadian competent authority may agree, under the proposed 
revised protocol, to treat the trust as a Canadian resident 
trust (i.e., by treating its trustee as a Canadian resident) 
for purposes of the exemption from the gains at death tax. The 
Canadian competent authority also can refuse to grant treatment 
as a Canadian resident trust if the trust does not meet ``terms 
and conditions satisfactory to such competent authority.'' The 
Technical Explanation states that this provision is ``intended 
to enable a trust that is a qualified domestic trust for U.S. 
estate tax purposes to be treated at the same time as a spousal 
trust'' for purposes of the Canadian gains at death tax.

Canadian gains at death tax credit for estate tax credit

    Paragraph 6 of new Article XXIX B is a reciprocal 
concession by Canada for the U.S. estate tax credit granted 
under paragraph 7 of new Article XXIX B for payments of the 
Canadian gains at death tax. Under this paragraph 6, Canadian 
residents and Canadian resident spousal trusts receive a credit 
for U.S. estate taxes and state inheritance taxes imposed with 
respect to U.S. situs property. The credit is only available 
where the U.S. tax is imposed upon the decedent's death or, in 
the case of a spousal trust, upon the death of the surviving 
spouse. Thus, for reasons similar to those discussed below with 
respect to paragraph 7, availability of the credit for U.S. 
estate and inheritance taxes is dependent upon when the 
relevant taxes are imposed. In situations where the taxes are 
imposed between the deaths of the two spouses, the credit 
apparently is not available (absent competent authority 
relief).

Estate tax credit for Canadian gains at death tax

    Under the proposed revised protocol, Paragraph 7 of new 
Article XXIX B provides in certain cases a U.S. estate tax 
credit for the Canadian Federal and provincial gains at death 
taxes. The credit is available only with respect to (1) a U.S. 
estate tax that is imposed either by reason of the death of an 
individual who was a U.S. citizen or resident at the time of 
the decedent's death, or (2) the U.S. estate tax imposed with 
respect to property remaining in the QDOT at the time of the 
death of the surviving spouse.
    To qualify for the credit, the Canadian taxes must be 
imposed at the death of the decedent, or the death of the 
surviving spouse in the case of taxes imposed with respect to 
property remaining in the QDOT. In addition, the Canadian gains 
at death taxes must be imposed on property situated outside the 
United States which is subject to the U.S. estate tax. The 
Canadian gains at death taxes are creditable against the U.S. 
estate tax regardless of whether the taxable event and the 
identity of the taxpayer are the same under Canadian law as 
under U.S. law. The amount of the allowable credit is computed 
in accordance with the provisions and subject to the 
limitations of U.S. internal law, except that the Canadian 
gains at death tax will be treated as ``a creditable tax'' 
under U.S. internal law as if it were a death tax rather than 
an income tax.
    The proposed revised protocol generally prevents a taxpayer 
from taking either a deduction or a credit for the same 
Canadian death tax against both his U.S. income tax and his 
estate tax liability. An exception will be available for the 
estate tax imposed on the QDOT at the death of the surviving 
spouse. No interest will be paid on any refunds of U.S. tax 
resulting from the credit for Canadian gains at death taxes.
Marital transfers

    Under the proposed revised protocol, the availability of 
the Canadian gains at death tax credit will be dependent upon 
when the U.S. estate tax is imposed and when the Canadian gains 
at death tax is imposed. There are nine different combinations 
of when these two taxes can be imposed with respect to marital 
transfers.13 The following discussion illustrates each of 
these possible combinations and the tax consequences of each 
under the proposed revised protocol. For purposes of each 
example, assume the following facts: an individual resident of 
the United States owns Canadian real property; the individual's 
spouse is not a U.S. citizen; the credit, if available, would 
be claimed within the 4-year limitation period under Code 
section 2014(e); 14 and U.S. tax is not eliminated by the 
application of any available credits under the proposed revised 
protocol and U.S. internal law.15
    \13\ The nine different combinations arise because the U.S. estate 
tax can be imposed on a marital transfer at three different times (date 
of death of first spouse, corpus distributions from QDOT between the 
deaths of spouses, and the date of death of second spouse) and the 
Canadian gains at death taxes also can be imposed at three different 
times (date of death of first spouse, sale of assets by spousal trust 
between deaths of spouses, and the date of death of second spouse).
    \14\ Under Code section 2014(e), the credit for foreign death taxes 
generally is only allowed with respect to foreign death taxes that are 
paid and for which credit is claimed within 4 years after the filing of 
the estate tax return.
    \15\ The hypothetical situations described below as possibly 
resulting in the timing results at issue are included only as examples, 
and are not meant to suggest that other facts would not also be 
accompanied by the same timing results. Furthermore, the analysis 
provided in each case only pertains to the specific fact patterns 
described.
---------------------------------------------------------------------------
            (1) U.S. estate tax and Canadian gains at death tax both 
                    imposed at death of first spouse
    This result could occur where there is a marital bequest to 
a trust, the QDOT election is not made, and the trust does not 
qualify for carryover basis under Canadian law (e.g., the 
Canadian competent authorities do not agree to treat the trust 
as a spousal trust).16 In such a case, both U.S. estate 
tax and Canadian death tax are imposed at the death of the 
first spouse.
    \16\ This is also the typical non-marital case in which a decedent 
passes away and his assets are inherited by someone other than his 
spouse; no deferral of either the U.S. estate tax or the Canadian death 
tax is available.
---------------------------------------------------------------------------
    A foreign death tax credit would be allowed under the 
proposed revised protocol for the Canadian death tax imposed on 
the estate of the first spouse. All the conditions stipulated 
by the proposed revised protocol are satisfied.
            (2) U.S. estate tax imposed at death of first spouse; 
                    Canadian gains at death tax imposed on sale of 
                    assets between death of spouses
    This case might arise where the property is transferred to 
a trust that meets the spousal trust requirements for Canadian 
tax purposes, but no QDOT election is made for U.S. tax 
purposes. The trust subsequently sells the property before the 
second spouse dies.
    The amount of Canadian death tax would not automatically be 
allowed as a credit under the proposed revised protocol, 
because the Canadian gains at death tax is not imposed at the 
death of either the first or second spouse. However, the 
competent authorities of the two countries may decide to grant 
relief under the proposed revised protocol.17 This 
analysis holds for all of the scenarios where the Canadian 
gains at death tax is imposed on the sale of an asset between 
the date of the two spouses' deaths (scenarios (5) and (8) 
below).
    \17\ Article 14 of the proposed revised protocol states that 
competent authority relief may be sought in cases where double taxation 
results from differences in the tax laws of the United States and 
Canada due to ``dispositions or distributions'' of property by a QDOT 
or a spousal trust.
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            (3) U.S. estate tax imposed at death of first spouse; 
                    Canadian gains at death tax imposed on death of 
                    second spouse
    This case might arise where the property is transferred to 
a trust that meets the spousal trust requirements for Canadian 
tax purposes, but no QDOT election is made for U.S. tax 
purposes and the trust holds the property until the second 
spouse dies.
    The Committee understands that a foreign death tax credit 
would be allowed in this case under the proposed revised 
protocol for the Canadian death tax imposed on the spousal 
trust.
            (4) U.S. estate tax imposed on corpus distributions from 
                    QDOT; Canadian gains at death tax imposed at death 
                    of first spouse
    This case might arise where the property is transferred to 
a trust that meets the requirements of a QDOT, but not those of 
a Canadian spousal trust (e.g., the Canadian competent 
authorities do not agree to treat the trust as a spousal 
trust), and there is a corpus distribution between the spouses' 
deaths.
    The credit for Canadian gains at death taxes apparently 
would not be allowed automatically under the proposed revised 
protocol because the U.S. estate tax (against which the 
Canadian tax would be credited) is not imposed by reason of the 
death of the first spouse or imposed on the QDOT upon the death 
of the surviving spouse. Rather, the U.S. estate tax sought to 
be reduced is being imposed on the QDOT under Code section 
2056A(b)(1)(A) on the distribution of property from the QDOT. 
Thus, a credit would be allowable only if the QDOT tax imposed 
under Code section 2056A(b)(1)(A) is determined to be the same 
as imposition of the estate tax upon the death of the first 
spouse. It does not appear that this is the result under either 
the internal U.S. law or the proposed revised protocol.
    As discussed previously, competent authority relief may be 
available under the proposed revised protocol.
            (5) U.S. estate tax imposed on corpus distributions from 
                    QDOT; Canadian gains at death tax imposed upon sale 
                    of assets between spouses' deaths
    This case is likely to occur where property is transferred 
to a trust which qualifies as both a QDOT for U.S. estate tax 
purposes and a spousal trust for Canadian death tax purposes, 
and the trust sells the property and distributes the proceeds 
to the second spouse before his or her death.
    The credit for Canadian gains at death taxes would not be 
available automatically under the proposed revised protocol for 
two reasons. First, as in scenario (4), the U.S. estate tax is 
not imposed by reason of the death of either spouse. In 
addition, as in scenario (2), the Canadian tax also is not 
imposed by reason of the death of either spouse. However, as 
discussed previously, competent authority relief may be 
available under the proposed revised protocol.
            (6) U.S. estate tax imposed on corpus distributions from 
                    QDOT; Canadian gains at death tax imposed at death 
                    of second spouse
    This case might arise where the trustee of the QDOT/spousal 
trust distributed property in-kind to the second spouse. There 
would be U.S. estate tax on the corpus distribution, but there 
may not be a Canadian capital gains tax until there is a 
disposition of the property by the second spouse or the second 
spouse dies.
    As in scenario (4), the credit apparently would not be 
available automatically because the U.S. estate tax is not 
imposed upon the death of either spouse. Competent authority 
relief may be available.
            (7) U.S. estate tax imposed at death of second spouse; 
                    Canadian gains at death tax imposed at death of 
                    first spouse
    This case may occur where the property is transferred to a 
trust that meets the requirements of a QDOT, but not those of a 
Canadian spousal trust (e.g., the Canadian competent 
authorities do not agree to treat the trust as a spousal 
trust), and the trust holds the property without distributions 
until the death of the second spouse.
    A credit would be allowed under the proposed revised 
protocol for the Canadian gains at death tax imposed on the 
estate of the first spouse. All the conditions of the proposed 
revised protocol are satisfied.
            (8) U.S. estate tax imposed at death of second spouse; 
                    Canadian gains at death tax imposed on sale of 
                    assets between death of spouses
    This case is likely to arise where property in the QDOT/
spousal trust is sold and the proceeds retained in the trust 
until the death of the second spouse.
    The credit would not be available automatically because the 
Canadian tax is not imposed upon the death of either spouse. As 
under scenario (2), competent authority relief may be sought.
            (9) Both U.S. estate tax and Canadian gains at death tax 
                    imposed at death of second spouse
    This is the typical case of the QDOT/spousal trust that 
holds the property throughout the remaining lifetime of the 
second spouse. There will be a U.S. QDOT estate tax and a 
Canadian death tax imposed at the death of the second spouse.
    A credit would be allowed under the proposed revised 
protocol for the Canadian gains at death taxes imposed on the 
spousal trust on the death of the second spouse. All the 
conditions required by the proposed revised protocol are 
satisfied.

Estate tax exemption for small estates

    Paragraph 8 of new Article XXIX B limits the U.S. estate 
tax that could be imposed on Canadian residents with small 
gross estates. Under this provision, if the worldwide estate of 
a Canadian resident is equal to or less than $1.2 million, the 
U.S. estate tax will apply only to any U.S. real estate or U.S. 
business property of a permanent establishment or fixed base in 
the United States. Gains on those two types of property are the 
only gains on which the situs country is permitted to impose 
income tax, including the gains at death tax, under Article 
XIII of the existing treaty.
    Paragraph 8 is similar to a provision contained in the U.S. 
model estate tax treaty and other U.S. estate tax treaties, 
except that those treaties generally do not impose a limitation 
on the size of the estate. The provision in the model treaty 
(and other similar treaties) are reciprocal concessions granted 
with respect to each country's estate tax. Because Canada 
imposes no estate tax, the concession in Paragraph 8 relates 
only to U.S. estate tax; however, as noted above, Canada 
already grants a similar concession with respect to the gains 
at death tax under the existing treaty. The Committee believes 
that this concession is appropriate given the special 
relationship between the United States and Canada. This 
concession should not necessarily be viewed as a precedent in 
future treaty negotiations with countries that do not impose an 
estate or inheritance tax.
    This provision benefits individuals with small estates who 
are treated as residents in the United States at death under 
U.S. internal estate tax law, but are treated as Canadian 
residents under the treaty.\19\ This provision, however, 
provides no benefit to a decedent who is a U.S. resident under 
the treaty definition but not under the U.S. estate tax 
definition. Such a person does not qualify for the small estate 
exemption; only Canadian residents (as defined by the treaty) 
may qualify.
    \18\ This can occur, because as noted above, the existing treaty 
and proposed revised protocol use an income tax definition of 
residency, rather than an estate tax definition.
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Effective date

    The provisions of the proposed revised protocol relating to 
taxes imposed at death generally are effective on a prospective 
basis. At the election of the taxpayer, however, all of these 
provisions (other than paragraph 1 applicable to charitable 
bequests) can be applied retroactively to the date of the 
enactment of TAMRA.\19\ Thus, the retroactive effective date 
applies reciprocally to the concessions made by the United 
States and the concessions made by Canada. Moreover, the 
retroactive relief applies even to provisions that are not 
aimed at providing TAMRA relief. For example, under the 
proposed revised protocol, the estate of a Canadian resident 
who had a small estate may be retroactively eligible for a 
refund of estate taxes previously paid with respect to assets 
exempted from U.S. estate tax under paragraph 8.
    \19\ To qualify, a taxpayer must file a claim for refund by the 
later of one year from the date that the proposed revised protocol 
enters into force or the date that such a claim must be filed under 
Canadian or U.S. law, as applicable.
---------------------------------------------------------------------------
    According to the Technical Explanation, the negotiators of 
the treaty believed that, while ``it is unusual for the United 
States to agree to retrospective effective dates,'' 
retroactivity was justified in this case ``given the fact that 
the TAMRA provisions were the impetus for negotiation of the 
Protocol and that the negotiations commenced soon after the 
enactment of TAMRA.'' The Committee wishes to clarify that 
retroactive relief is desirable, in part, because of the 
special relationship between the United States and Canada and 
should not necessarily be viewed as a precedent by other 
countries.

                              b. Royalties

In general

    The proposed revised protocol restricts source country 
taxation of royalties to a greater extent than the existing 
treaty, although not to the extent provided for in the U.S. 
model. Compared to the existing treaty, the proposed revised 
protocol expands the categories of royalties that are exempt 
from source-country taxation, and modifies the rule for 
determining the source of royalty payments.
    As discussed in Part III., above, the existing treaty 
contains a two-tier (10-percent or exempt) limitation on 
source-country taxation of royalties. The proposed revised 
protocol expands the type of royalties that are eligible for 
exemption from source country taxation. The expanded category 
of exempt royalties expressly includes payments for the use of, 
or the right to use, computer software, patents, and 
information (unless provided in connection with a rental or 
franchise agreement) concerning industrial, commercial or 
scientific experience.

``Shrink wrap'' software

    Internal Revenue Service (``IRS'') has issued a private 
letter ruling holding that no U.S. withholding tax is due on 
outbound software royalties paid by a U.S. person under a 
treaty like the existing treaty.\20\ Furthermore, prior to the 
conclusion of the negotiation of the proposed revised protocol, 
the Canadian government issued a ruling that exempted from 
withholding royalty payments made by a taxpayer with respect to 
``shrink wrap'' software sold under a general license. This 
result was adopted as policy later in 1994. Thus, the inclusion 
of software royalties under the exempt category in the proposed 
revised protocol may have little practical effect with respect 
to ``shrink wrap'' royalties, because they appear to be exempt 
from Canadian withholding tax under current Canadian law or 
practice. This result is not the case with respect to other 
types of software royalties, however.
    \20\ Private letter rulings relate to particular taxpayers and are 
not intended to be used or cited as precedent. In PLR 9128025 (April 
12, 1991), the IRS held that payments by a U.S. distributor of computer 
software to a foreign developer of the software, under a license to 
reproduce the developer's software in the United States, are exempt 
from U.S. withholding tax under the applicable treaty. Although the 
identity of the applicable tax treaty was not revealed in the ruling, 
the language of the article that the IRS relied on for the applicable 
treaty is identical to the text of the existing treaty with Canada.
---------------------------------------------------------------------------

Bifurcation

    The proposed revised protocol extends the exemption rate on 
royalties to cover amounts paid for the use of patents and 
certain know how. Contrary to the U.S. model and the provisions 
of many U.S. tax treaties with other industrial nations, no 
similar relief is available for royalties on trademarks, which 
will continue to be taxed at a 10-percent rate.
    The Technical Explanation indicates that in a case where 
royalties are paid for a bundle of rights in a mixed contract 
or similar arrangements, some of which, by themselves, would be 
exempt from source-country taxation, and others would be 
taxable, exemption would apply to those royalties to the extent 
that they are paid for the former. This is the first time that 
the United States has explicitly confirmed in the Technical 
Explanation a requirement of bifurcating a single payment of 
royalties into a tax-exempt and a taxable portion in a 
bilateral treaty.\21\ Hence, there is no precedent to determine 
whether the policy may work effectively. It can be argued that 
the concept of un-bundling royalties attributable to a bundle 
of rights including both trademark and know-how rights applies 
an arms-length principle in the very type of case where an 
arms-length principle is least effective; that is, where the 
intangible may be unique.
    \21\ Other U.S. tax treaties provide that different classes of 
royalties are subject to differing rates. For example, the treaty with 
Spain provides for a 10 percent rate on trademark royalties and an 8 
percent rate for royalties with respect to know-how. This 2-percent 
spread in rates for two different types of taxable royalties may not, 
however, have the same impact as treating one type as exempt from tax 
and the other as taxable at a 10-percent rate, as under the proposed 
revised protocol.
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    As part of its consideration of the proposed revised 
protocol, the Committee asked the Treasury Department to 
address the Committee's concern that the bifurcation notion is 
likely to cause uncertainty and to be difficult for taxpayers 
to apply in practice. The Committee also made clear that it 
supports the efforts of the Treasury Department to reduce to 
zero the withholding rates on all royalties, and asked the 
Treasury Department to address the Committee's concern that the 
bifurcation approach of the proposed revised protocol has the 
potential to erode a zero-withholding-rate policy in future 
treaty negotiations.
    In its July 5, 1995 letter to Chairman Helms explaining the 
royalty provisions of the proposed revised protocol in greater 
detail, the Treasury Department wrote:

                                                      July 5, 1995.
Hon. Jesse A. Helms,
U.S. Senate,
Washington, DC.
    Senator Helms: At the June 13th hearing before the 
Committee on Foreign Relations regarding the pending tax 
conventions and protocols, you asked us to provide you with a 
letter explaining the royalty provisions of the Protocol with 
Canada in greater detail. I am writing in response to that 
request.
    Although the provisions of the Protocol do not fully 
reflect the U.S. policy of exemption for all royalties, they 
represent a substantial improvement over our current Income Tax 
Convention with Canada. Under the current Convention, most 
types of cross-border royalty payments are subject to tax in 
the country of source at a rate of 10 percent. The United 
States made this a major issue in the Protocol negotiations and 
did persuade Canada to exempt most types of royalties from 
source country taxation.
    Royalties paid for the use of trademarks remain subject to 
a withholding tax of 10 percent because Canada was unwilling to 
grant a complete exemption at this time. Canada did agree, 
however, to discuss further reductions in withholding within 
three years of the date on which the Protocol enters into 
force. The Treasury Department intends to continue to pursue a 
zero rate of withholding for all royalties in future 
negotiations with Canada, as well as with other countries.
    In the meantime, we are confident that the provisions of 
the Protocol can be administered satisfactorily to determine 
the proper taxation of ``bundled'' royalty payments. A number 
of our existing treaties provide different rates of tax for 
various classes of royalties. Our recent treaty with Spain, for 
example, actually provides three different rates. We are not 
aware of any problem under these treaties in dividing a 
payment, where necessary, into separate classes.
    The Treasury Department Technical Explanation to the 
Protocol with Canada explicitly confirms that ``bundled'' 
royalty payments may be bifurcated to obtain a zero rate of 
withholding on the exempt portion, and that the United States 
and Canada will work together in good faith to resolve any 
administrative issues that may arise. As indicated by the 
attached press release, the Canadian Government has confirmed 
in advance that it fully agrees with the understandings 
reflected in our Technical Explanation.
    Please let me know if you have any further questions 
regarding these provisions.
            Sincerely yours,
                                         Leslie B. Samuels,
                                  Assistant Secretary (Tax Policy).
    Similarly, in the July 5, 1995 Treasury letter (to Senator 
Thompson) responding to various questions that were raised as 
part of the Committee's consideration of the proposed revised 
protocol, the Treasury Department stated:

          1. How will the current procedures adequately 
        determine proper taxation where royalties are paid for 
        in a bundle of rights in a contract that mixes 
        trademarks taxable at the 10 percent rate and the 
        exempt royalties?
          We do not anticipate problems in determining the 
        proper taxation of ``bundled'' royalty payments. A 
        number of our existing treaties provide different rates 
        of tax for various classes of royalties. Our recent 
        treaty with Spain actually provides three different 
        rates. We are not aware of any problem that has arisen 
        under these treaties in dividing a payment, where 
        necessary, into separate classes.
          The Treasury Department Technical Explanation to the 
        Protocol with Canada (to which Canada has agreed) 
        explicitly assures taxpayers that ``bundled'' royalty 
        payments may be bifurcated and that the United States 
        and Canada will work together to resolve any 
        administrative issues that may arise in applying the 
        royalty provisions of the Protocol.

    Thus, while the Treasury Department has assured the 
Committee that the provisions of the proposed revised protocol 
that call for a differentiated rate of taxation on royalties 
will be administered satisfactorily to determine the proper 
taxation of ``bundled'' royalty payments, the Committee 
emphasizes its concern that in addition to its potential to 
erode a zero withholding-rate policy with respect to royalties, 
such differentiation creates administrative burdens that have 
not been identified clearly prior to Senate ratification. The 
Committee would like to be further assured of the 
administrability of this unique provision in actual operation.

Exchange of notes regarding broadcasting royalties

    The proposed revised protocol permits the treaty countries 
to agree, through an exchange of diplomatic notes (that is, 
without any additional treaty ratification procedures), to 
expand further the exempt category to cover payments with 
respect to broadcasting. The Committee is extremely concerned 
about the self-executing nature of this provision,\22\ 
notwithstanding the fact that the treaty modification 
authorized to be effective without further ratification 
procedures would conform the treatment of certain royalties to 
the preferred U.S. position.
    \22\ The approach taken in the proposed revised protocol differs, 
for example, from the approach taken in the proposed treaty and 
protocol with Kazakhstan. There, the proposed revised protocol 
explicitly refers to a future change to a significant term of the 
treaty (i.e., a lower rate of withholding tax would be applicable 
between the United States and Kazakhstan if any lower rate is agreed to 
in a treaty between Kazakhstan and another OECD country), but the 
Memorandum of Understanding indicates that such change would be subject 
to ratification by the United States and by Kazakhstan.
---------------------------------------------------------------------------
    Therefore, the Committee recommends that the Senate give 
its advice and consent to the proposed revised protocol with 
the declaration that the Treasury Department shall inform the 
Committee as to the progress of all negotiations with and 
actions taken by Canada that may affect the application of the 
provision of the proposed revised protocol relating to payments 
with respect to broadcasting as may be agreed in an exchange of 
notes between the United States and Canada.
    The Committee does not favor an approach under which 
changes to the terms of a treaty or protocol are made without 
the subsequent advice and consent of the Senate. The Committee 
recognizes, however, that the unique relationship that the 
United States has with Canada, our major trading partner and a 
nation with which the United States has a long, cordial 
relationship, justifies acceptance of this particular provision 
in this particular case, with the declaration described above. 
The Committee strongly disapproves of taking this type of 
approach in future treaty negotiations.
Source rules

            Existing treaty
    The existing treaty includes a source rule for royalties 
which sources royalties by place of use, if the place of use is 
Canada or the United States. Similarly, U.S. internal law 
sources royalties based on the place of its use (even if the 
place of use is outside the United States or Canada). For 
example, if a U.S. resident pays a royalty to a Canadian 
resident for the right to use intangible property exclusively 
in Mexico, then under internal U.S. law the Canadian resident 
has received no U.S. source income, and no U.S. tax under Code 
sections 871, 881, 1441, or 1442 applies to the royalty. On the 
other hand, if the same Canadian resident receives a royalty 
from a Mexican resident for the right to use intangible 
property exclusively in the United States, then under both U.S. 
internal law and the existing U.S.-Canada treaty, the Canadian 
resident has received U.S. source income despite the absence of 
a payment from a U.S. person.23 As a result, the Code will 
impose a U.S. gross-basis tax at the 10-percent rate provided 
in the existing treaty.24
    \23\ Under the U.S.-Mexico treaty, such a royalty would be treated 
as arising from sources in Mexico.
    \24\ There may be no U.S. withholding agent to collect and pay over 
the tax, however.
---------------------------------------------------------------------------
    If a Canadian resident pays a royalty to a U.S. resident 
for the right to use intangible property exclusively in the 
United States, then under internal U.S. law that royalty 
generates U.S. source income and does not increase the U.S. 
resident's foreign tax credit limitation. Under the existing 
treaty that income generally would not be taxable by Canada. 
Under the elimination of double taxation article, that income 
generally would be treated as arising in the United States.
    Only where the payment is made by a resident of the United 
States or Canada, for the right to use the property outside the 
United States or Canada, does the existing treaty source 
royalties outside the country of use. In that case the existing 
treaty sources the royalty by reference to the country where 
the payor resides (or where the payor has a permanent 
establishment or fixed base, if the royalty was incurred and 
borne by the permanent establishment or fixed base). And if the 
rule sourcing the royalty outside the country of use is 
applicable, then under the elimination of double taxation 
article, the royalty will only be deemed to arise in a treaty 
country if the treaty otherwise authorizes taxation of the 
royalty by that country. For example, if a resident of Canada 
pays a copyright royalty to a U.S. resident for the right to 
use a literary work exclusively in the United Kingdom, and 
neither person has a permanent establishment or fixed base in 
the country in which the other person resides, then 
notwithstanding that the royalty may be sourced in Canada under 
the existing royalty provision, it is not deemed to arise in 
Canada under the elimination of double taxation article, 
because Canada generally is precluded by treaty from taxing a 
literary royalty paid to a U.S. resident.
            Proposed revised protocol
    The proposed revised protocol reverses the source rules in 
the existing treaty. It replaces the source rule in the 
existing treaty with a provision similar to the corresponding 
provision in several U.S. treaties, including the U.S. treaties 
with Australia, New Zealand, and Mexico. In general, the 
proposed revised protocol sources a royalty by reference to the 
country where the payor resides (or where the payor has a 
permanent establishment or fixed base, if the royalty was 
incurred and borne by the permanent establishment or fixed 
base). Only when the payor is not a resident of the United 
States or Canada are royalties sourced on the basis of the 
place of use of the property. As a result, then, the general 
royalty source rule under the proposed revised protocol 
(sourced at residence of the payor) differs from the internal 
U.S.-law rule (sourced at place of use).
    For example, if a Canadian resident (who has no permanent 
establishment in the United States) pays a royalty to a U.S. 
resident for the right to use intangible property exclusively 
in the United States, then under internal U.S. law, that 
royalty generates U.S. source income and does not increase the 
U.S. resident's foreign tax credit limitation. However, under 
the proposed revised protocol, that income could be subject to 
Canadian tax. If so, then under the elimination of double 
taxation article, that income would also be treated as arising 
outside the United States. The Committee believes that under 
current business practices, this situation would arise in 
relatively few cases (compared to the more common presence of a 
permanent establishment in the country where the property is 
used).
    The effect of this provision is that certain royalty 
payments that are treated as U.S. source income under both the 
existing treaty and U.S. internal law would be treated, under 
the proposed revised protocol, as foreign source income. This 
change prevents the United States from imposing withholding tax 
on some royalties on which U.S. tax may currently be imposed 
(as in the above example, where a resident of Canada with no 
permanent establishment in the United States pays royalties to 
a resident of the United States, for the use of property in the 
United States). In addition, treating such royalty income as 
foreign source income can enhance a U.S. taxpayer's foreign tax 
credit limitation. A U.S. taxpayer that has excess foreign tax 
credits may offset the U.S. tax imposed on such income, causing 
further erosion of the U.S. tax base.25
    \25\ While the proposed revised protocol will permit the United 
States to impose tax in the reverse situation (where a resident of the 
United States pays royalties to a resident of Canada for the use of 
property in Canada), no U.S. withholding tax will actually be imposed 
under internal U.S. law.
    Under Article XXIX of the existing treaty (Miscellaneous 
Rules), a Canadian resident may elect to be taxed under the 
U.S. internal rules to determine the source of the income, to 
the extent it is favorable.26 Such an election may be made 
by a Canadian resident who receives a royalty for the use of 
property outside the United States that is paid by a U.S. 
person. The Committee has been assured, however, that under 
current business practices, this situation will arise in 
relatively few cases (compared to the currently more common 
situation in which a U.S. resident receives a royalty for the 
use of property outside the United States that is paid by a 
Canadian person).
    \26\ As stated in the Technical Explanation, however, ``under a 
basic principle of tax treaty interpretation recognized by both 
Contracting States, the prohibition against so-called `cherry-picking,' 
the Canadian resident would be precluded from claiming selected 
benefits under the Convention (e.g., the tax rates only) and other 
benefits under U.S. domestic law (e.g., the source rules only) with 
respect to its royalties.'' (Technical Explanation at 12.)
---------------------------------------------------------------------------
    Finally, the fact that the proposed revised protocol 
changes the source of the royalty payments might induce a 
third-country resident to try to use the unusual royalty source 
rules of the proposed revised protocol to avoid U.S. tax. This 
might be attempted, for example, by structuring a license 
through a Canadian company that qualifies for derivative 
benefits under the proposed revised protocol, as discussed 
below. Because the source rules in the proposed revised 
protocol differ from most other U.S. treaties, taxpayers may 
seek to take advantage of the inconsistencies among U.S. 
treaties in structuring licensing arrangements.27 The 
Committee does not favor such inconsistencies in the source 
rules, but believes that the opportunity to achieve this result 
is limited as a practical matter.
    \27\ See also the discussion of the derivative benefits rule in 
Part VI. C., below, of this report, (relating to ``Limitation on 
Benefits'').
---------------------------------------------------------------------------

                       c. limitation on benefits

In general

    The proposed revised protocol is intended to limit double 
taxation caused by the interaction of the tax systems of the 
United States and Canada as they apply to residents of the two 
countries. At times, a person who is not a resident of either 
country seeks certain benefits under the income tax treaty 
between the two countries (referred to as ``treaty shopping''). 
Under certain circumstances, and without appropriate 
safeguards, the nonresident is able indirectly to secure these 
benefits by establishing a corporation (or other entity) in one 
of the countries. Such an entity, as a resident of that 
country, is entitled to the benefits of the treaty without such 
safeguards. Additionally, it may be possible for the third-
country resident to reduce the income tax base of the treaty-
country resident by having the latter pay out interest, 
royalties, or other amounts under favorable conditions (i.e., 
it may be possible to reduce or eliminate taxes of the resident 
company by distributing its earnings through deductible 
payments or by avoiding withholding taxes on the distributions) 
either through relaxed tax provisions in the distributing 
country or by passing the funds through other treaty countries 
(essentially, continuing to treaty shop), until the funds can 
be repatriated under favorable terms.
    The proposed revised protocol contains a limitation on 
benefits or ``anti-treaty shopping'' article that permits the 
United States to deny treaty benefits to a resident of Canada 
unless requirements, similar in many respects to those 
contained in recent U.S. treaties and in the branch tax 
provisions of the Code, are met. This provision replaces very 
limited anti-abuse provisions restricting benefits under the 
existing treaty. Nevertheless, there are significant 
differences between the provisions of the proposed revised 
protocol and the corresponding provisions of other U.S. 
treaties and internal U.S. law. Such differences include:
    The lack of a base-erosion rule in the test relating to 
subsidiaries of publicly-traded companies, to limit potentially 
abusive structures.
    The testing of aggregate vote and value in the ownership 
and base-erosion test without any appropriate anti-abuse 
provisions (e.g., a rule to prohibit the issuance of shares 
that achieve disproportionate allocation of rights).
    The ability to satisfy the active-business test if a person 
related to the entity claiming treaty benefits is conducting 
the active business. As in some other U.S. treaties, it is 
unclear to what extent such a rule may open the active-business 
test to potential abuse.
    The derivative benefits rule, which extends benefits of the 
proposed revised protocol to a Canadian company that is wholly 
owned by third-country residents, even though the ultimate 
owners may not obtain the identical benefits under the treaty 
between their country of residence and the United States.
    Unlike most other corresponding U.S. treaty provisions, the 
proposed anti-treaty-shopping article does not affirmatively 
provide Canada any basis on which to deny any treaty benefits. 
It does, however, include an explicit understanding, not found 
in any other U.S. treaty, as to the noninterference of the 
treaty with application by each country of its internal anti-
abuse rules. Such a rule permits Canada to unilaterally change 
its standards in implementing the anti-avoidance provisions. 
Thus, a U.S. person could face uncertainty in determining its 
ability to claim benefits under the proposed revised 
protocol.28 This explicit understanding might also be 
construed by some as creating a negative inference about the 
applicability of internal-law anti-avoidance rules in other 
treaties and protocols of the United States. In addition, the 
fact that the anti-treaty-shopping provisions of the proposed 
revised protocol are looser than, or differ from, comparable 
provisions in other U.S. tax treaties could create an 
unintended disincentive to third countries to enter into 
bilateral tax treaties with the United States that include 
tighter provisions relating to limitations on benefits.
    \28\ The Technical Explanation suggests that this concept is 
implicit in all tax treaties. It could therefore be argued that 
uncertainty resulting from changes in internal law could arise under 
any tax treaty.
    In accepting this unusual set of provisions, the Committee 
notes that treaty shopping through the United States is 
unlikely given its generally relatively high tax rates. The 
Committee believes that, with respect to whether any negative 
inference is created by explicit reference to internal-law 
anti-abuse rules, the better view is that no negative inference 
is created; and moreover, certainly none is intended. The 
Committee does not believe that the proposed revised protocol 
suffers from any greater degree of uncertainty in application 
of treaty partners' internal anti-abuse rules than does any 
other treaty or protocol of the United States. Further, the 
Committee has given consideration to the argument that U.S. 
policy is not impaired if a treaty partner (Canada in this 
case) does not wish to establish reciprocal limitation on 
benefit rules, so long as the treaty partner does not object to 
establishment of such rules protecting U.S. interests. In 
considering these issues, the Committee requested a response 
from the Treasury Department. In the July 5, 1995 Treasury 
letter, the Treasury Department provided the following 
---------------------------------------------------------------------------
assurances:

          3. Since the limitations on benefits are determined 
        by Canadian domestic law, doesn't this provision result 
        in uncertainty as to the determination of a U.S. 
        person's ability to claim benefits under the proposed 
        protocol? Will this provision contribute to an 
        unintended disincentive to third countries to enter 
        into bilateral tax treaties with the U.S. because this 
        provision might erroneously be perceived as 
        representing U.S. unwillingness to accept treaty 
        partners' attempts to protect themselves from erosion 
        of the tax bases?
          The limitation on benefits article does not create 
        any uncertainty regarding the ability of U.S. persons 
        to claim treaty benefits. The article simply confirms 
        that it does not prevent either country from invoking 
        applicable anti-avoidance rules to recharacterize a 
        particular transaction if necessary to prevent abuse of 
        the treaty. Neither the United States nor Canada 
        believes that it is necessary to confirm this principle 
        explicitly, but Canada wanted to ensure that the 
        unilateral nature of the other limitation on benefits 
        provisions of the Protocol would not give rise to any 
        negative inference regarding the applicability of such 
        anti-avoidance rules in this case. The Technical 
        Explanation states that no negative inference should be 
        drawn regarding the applicability of such rules in 
        connection with other United States or Canadian tax 
        treaties.
          Both the United States and Canada take the position, 
        which is supported by the Commentaries to the OECD 
        Model Convention, that domestic anti-avoidance rules 
        apply in connection with all of their treaties. Since 
        these rules are applicable under the current treaty 
        with Canada, the Protocol does not expand or otherwise 
        modify the applicability of such rules. The application 
        of such rules (such as anti-conduit, substance-over-
        form, and step-transaction rules) is essential to the 
        prevention of tax evasion in the United States as well 
        as in Canada.
          The unilateral nature of the remainder of the 
        limitation on benefits article will not create any 
        concern among potential treaty partners. The Technical 
        Explanation explains that these provisions are 
        unilateral at Canada's request. This decision was 
        properly left to Canada, because the issue of ``treaty-
        shopping'' into Canada does not implicate any U.S. tax 
        policy or fiscal interest. The limitation on benefits 
        provisions of all other U.S. treaties, including those 
        now before the Committee, apply reciprocally. This 
        Protocol will not be taken as any indication of a 
        change in U.S. policy.

Qualifying person

    Under the proposed new anti-treaty-shopping article, a 
resident of Canada is not entitled to the benefits of the 
treaty from the United States unless it is a so-called 
``qualifying person,'' or satisfies an active business test, a 
derivative benefits test, or the U.S. competent authority 
otherwise grants treaty benefits based on criteria set forth 
below.
    A qualifying person must be a Canadian resident. Having 
satisfied that criterion, an individual or an estate will be a 
qualifying person. The term qualifying person also includes a 
company or trust that satisfies an ownership and ``base 
erosion'' test. The term includes a company or trust that 
satisfies an exchange-traded test, and a company that is 
closely held by exchange-traded companies or trusts. Also 
qualifying are Canadian governmental entities and 
instrumentalities, as well as certain not-for-profit or 
employee benefits organizations.

Exchange-traded company or trust or its subsidiary

    Under the exchange-traded test, a company or trust that is 
a resident of Canada is a qualifying person if there is 
substantial and regular trading in its principal class of 
shares or units on a recognized stock exchange. The term 
``recognized stock exchange'' includes the NASDAQ System owned 
by the National Association of Securities Dealers, Inc. in the 
United States; any stock exchange registered with the 
Securities and Exchange Commission as a national securities 
exchange for the purposes of the Securities Exchange Act of 
1934; any Canadian stock exchange that is a ``prescribed stock 
exchange'' under the Income Tax Act; and any other stock 
exchange agreed upon by the two countries in an exchange of 
notes, or by the competent authorities of the two countries. At 
the time the proposed revised protocol was signed, ``prescribed 
stock exchanges'' were the Alberta, Montreal, Toronto, 
Vancouver, and Winnipeg Stock Exchanges.
    In order for a company to satisfy the test for being 
closely held by exchange-traded companies or trusts, more than 
50 percent of the vote and value of the company's shares (other 
than debt substitute shares) must be owned, directly or 
indirectly, by five or fewer persons each of which is a company 
or trust that is exchange traded as provided above, provided 
that each company or trust in the chain of ownership is either 
a qualifying person, or a U.S. resident or citizen. The term 
``debt substitute share'' refers to certain shares issued in 
exchange or substitution for debt in certain cases of financial 
difficulty, as described in section 248(1)(e) of the Canadian 
Income Tax Act (part of the definition of the term ``term 
preferred share''). The term also refers to such other type of 
share as may be agreed upon by the competent authorities of the 
treaty countries.
    This rule for subsidiaries of exchange-traded companies is 
similar to a provision in the U.S.-Netherlands treaty, but 
omits certain provisions that can be regarded as attempts to 
prevent abuse. Like the U.S. branch tax rules, the Netherlands 
treaty allows benefits to be afforded to the wholly owned 
subsidiary of a publicly-traded company. Unlike any other 
existing treaty, but like the proposed revised protocol, the 
Netherlands treaty provides that benefits must be afforded to 
certain joint ventures of publicly-traded companies. However, 
the Netherlands treaty requires that if benefits are to be 
afforded a company resident in a treaty country on the basis of 
public trading in the stock of the company's shareholder or 
shareholders, then the company seeking treaty benefits must 
also meet one of two additional tests that measure base 
erosion. That is, the company either must not be a ``conduit 
company'' or, if it is a conduit company, the company must meet 
a ``conduit company base-reduction test.'' 29 There are no 
additional tests that measure base erosion that apply to a 
Canadian company that seeks treaty benefits on the basis of 
ownership by exchange-traded companies. A comparable provision 
exists under the branch profits tax provision of the U.S. 
internal law. Under that provision, only a wholly-owned 
subsidiary of a publicly-traded corporation that is organized 
under the laws of the same country may be treated as a 
``qualified resident'' of its country of residence. 
Consequently, this provision of the proposed revised protocol 
is less stringent than U.S. tax policy in this area under both 
our internal law and existing treaty practices.
    \29\ Under the Netherlands treaty, a conduit company is one that 
pays out currently at least 90 percent of its aggregate receipts that 
are deductible payments (including royalties and interest, but 
excluding those at arm's length for tangible property in the ordinary 
course of business or services performed in the payor's residence 
country). A conduit company meets the conduit base-reduction test if 
less than a threshold fraction (generally 50 percent) of its gross 
income is paid to associated enterprises subject to a particularly low 
tax rate (relative to the tax rate normally applicable in the payor's 
residence country).
Ownership and base-erosion test

    A company satisfies the ownership requirement of the 
ownership and base-erosion test if 50 percent or more of the 
vote and value of the shares (other than debt substitute 
shares) are not owned, directly or indirectly, by persons other 
than qualifying persons, or U.S. residents or citizens. A trust 
satisfies the ownership and base-erosion test if 50 percent or 
more of the beneficial interest in the trust is not owned, 
directly or indirectly, by persons other than qualifying 
persons, or U.S. residents or citizens. This rule could, for 
example, result in denial of benefits of the reduced U.S. 
withholding tax rates on dividends or royalties paid to a 
Canadian company that is controlled by individual residents of 
a third country.
    This ownership requirement is not as strict as that 
contained in the anti-treaty-shopping provision proposed at the 
time that the last U.S. model income tax treaty was proposed, 
which required 75-percent ownership by residents of the 
person's country of residence, in order to preserve benefits. 
On the other hand, it is in some ways similar to provisions in 
recently negotiated treaties. It differs from other treaties, 
however, in at least two respects.
    First, like the U.S.-Netherlands treaty (and unlike most 
other U.S. treaties), a Canadian entity determines whether the 
ownership requirement is met, in part, by reference to whether 
the owners of that entity are themselves entities that have met 
the ownership and base-erosion test. However, in contrast to 
the corresponding provision in the Netherlands treaty (Article 
26(1)(d)(i)), the relevant portion of the proposed Canadian 
protocol is worded in the negative. An effect of the wording of 
this provision in the negative is that intervening tiers of 
companies are also treated as qualifying persons, or not, by 
reference to the ultimate beneficial owners. This aspect of the 
proposed revised protocol is similar to the proposed treaty 
with France but differs from other U.S. tax treaties, including 
the proposed treaty with Portugal and the existing treaty with 
the Netherlands.
    A second difference between the ownership requirement in 
the proposed revised protocol and the ownership requirements in 
other recent treaties concerns the application of the vote and 
value tests to multiple classes of shares. In order for an 
entity to meet the corresponding provisions in some treaties, 
such as the U.S.-Germany treaty, appropriate persons must own 
50 percent of each class of the entity's shares. Under other 
treaties, such as the U.S.-Israel treaty (as modified by its 
second protocol) and the U.S. Netherlands treaty, the 
corresponding provision is applied by reference to the 
aggregate votes and values represented by all classes of shares 
(as is true in the proposed revised protocol), but anti-abuse 
provisions are inserted to prevent avoidance of the 
requirements by issuing classes of shares bearing rights that 
achieve disproportionate allocations among taxpayers. The 
proposed revised protocol omits any similar anti-abuse 
provisions. Thus, in contrast to a case arising under another 
treaty, in a case arising under the proposed revised protocol 
such abuses must be addressed by the IRS, if at all, by 
exercising its authority provided outside the treaty, and 
recognized in paragraph 7 of the limitation on benefits 
article.
    A company or trust that meets the foregoing ownership 
requirements must also meet a base-erosion requirement in order 
to satisfy the ownership and base-erosion test. This 
requirement is met only if the amount of the expenses 
deductible from gross income that are paid or payable by the 
company or trust for its preceding fiscal period (or, in the 
case of its first fiscal period, that period) to persons that 
are not qualifying persons, or U.S. residents or citizens, is 
less than 50 percent of its gross income for that period. This 
rule is of a type commonly referred to as a ``base erosion'' 
rule and is necessary to prevent a corporation, for example, 
from distributing (including paying, in the form of deductible 
items such as interest, royalties, service fees, or other 
amounts) most of its income to persons not entitled to benefits 
under the treaty. If payments are made, for example, from one 
Canadian person to another Canadian person that is not a 
qualifying person, the payor would have to know that the payee 
is in fact a qualifying person in order to obtain the favorable 
rate under the protocol. The Committee believes that this 
circumstance may be relatively rare, and therefore should not 
create a significant problem in the administration of the 
provision.

Active-business test

    Under the active-business test, treaty benefits with 
respect to certain income are available to a Canadian resident 
that is not a qualifying person, if that Canadian resident, or 
a person related to that Canadian resident, is engaged in the 
active conduct of certain types of trades or businesses in 
Canada. A trade or business for this purpose means any trade or 
business other than the business of making or managing 
investments, unless carried on with customers in the ordinary 
course of business by a bank, an insurance company, a 
registered securities dealer or a deposit-taking financial 
institution. In this case, benefits are provided with respect 
only to income derived from the United States in connection 
with or incidental to that trade or business, including any 
such income derived directly or indirectly by that resident 
person through one or more other persons that are residents of 
the United States. Under the proposed revised protocol, income 
is deemed to be derived from the United States in connection 
with the active conduct of a trade or business in Canada only 
if that trade or business is substantial in relation to the 
activity carried on in the United States giving rise to the 
income in respect of which U.S. treaty benefits are claimed.
    This provision corresponds to provisions found in other 
recent U.S. treaties, although it is not identical to any of 
them. For example, where the proposed revised protocol provides 
treaty benefits if the active trade or business in connection 
with which the income is earned is carried on by a related 
person, or received indirectly through a related person, the 
Netherlands treaty provides a more elaborate set of attribution 
rules, and the German treaty is interpreted in a memorandum of 
understanding to operate under similar principles.30
    \30\ For example, under the limitation on benefits provision of the 
U.S. treaty with the Netherlands, the committee report states, ``the 
active business test takes into account the extent to which the person 
seeking treaty benefits either is itself engaged in business, or is 
deemed to be so engaged through the activities of related persons. . . 
. Attribution for this purpose, although generally not set forth in the 
literal language of the active business test language in other recent 
treaties, has been used under those treaties.'' ``Report of the Senate 
Committee on Foreign Relations on the 1992 U.S.-Netherlands Income Tax 
Treaty and 1993 Protocol,'' Sen. Exec. Rept. 103-19, 103d Cong., 1st 
Sess. at 117 (1993). See also ``Understandings Regarding the Scope of 
the Limitation on Benefits Article in the Convention between the 
Federal Republic of Germany and the United States of America,'' Example 
II.
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    The Technical Explanation indicates that for purposes of 
the active business test under the proposed revised protocol, 
the term ``related person'' has the same meaning as under Code 
section 482, which permits the IRS to reallocate items between 
two or more organizations, trades, or business that are owned 
or controlled directly or indirectly by the same interests. 
This definition of related party generally depends on all the 
facts and circumstances, and does not provide a bright-line 
test ensuring certainty to taxpayers that a more mechanically 
applied attribution rule provides.
Derivative benefits rule

    The limitation on benefits article in the proposed revised 
protocol includes a ``derivative benefits'' provision 
corresponding to those found in only a limited number of other 
limitation on benefit articles (contained in the U.S. treaties 
with the Netherlands, Mexico, and Jamaica, and the proposed 
treaty with France), under which a Canadian company is entitled 
to reduced U.S. tax on dividends, interest, and royalties based 
on the eligibility of its stockholders, who may be residents of 
a third country, for treaty relief at least as favorable under 
a treaty between the United States and the third country. It 
should be noted that this provision reflects a significant 
departure from the derivative benefits article contained in 
almost all other U.S. tax treaties, in that it does not require 
any same-country ownership of the Canadian corporation claiming 
the relevant treaty benefits.\31\ In other words, a Canadian 
entity that is 100-percent owned by third-country residents and 
that does not otherwise have a nexus with Canada (e.g., by 
engaging in an active trade or business there) may be entitled 
to claim certain benefits under the proposed revised protocol.
    \31\ Article 26(1)(c)(iii) of the U.S.-Netherlands tax treaty, for 
example, requires 30-percent Dutch ownership of the entity claiming 
derivative benefits. The other 70 percent of the company must be owned 
by residents of the United States or of members of the European Union.
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    Under this provision, a Canadian resident company is 
entitled to the benefits of Articles X (Dividends), XI 
(Interest) and XII (Royalties) if it satisfies an ownership 
requirement and a base-erosion requirement. The base-erosion 
requirement matches the corresponding requirement under the 
ownership and base-erosion test for status as a ``qualifying 
person.'' To satisfy the ownership requirement, however, a 
different test is used. Under the derivative benefits rule, 
shares that represent more than 90 percent of the aggregate 
vote and value represented by all of its shares (other than 
debt substitute shares) must be owned, directly or indirectly, 
by persons each of whom is a qualifying person, a U.S. resident 
or citizen or a person who meets each of three conditions.
    First, the person must be a resident of a country with 
which the United States has a comprehensive income tax treaty, 
and must be entitled to all of the benefits provided by the 
United States under that treaty. The effectiveness of this 
requirement in limiting treaty-shopping opportunities could be 
questioned in cases where U.S. treaty with the third country of 
which the person is a resident does not itself contain a 
limitation on benefits provision (which are contained in fewer 
than half of U.S. bilateral income tax treaties), or provides 
less restrictive rules. However, because of the special 
relationship of the United States with Canada and the unique 
reasons that make the limitation on benefits provisions under 
the proposed revised protocol acceptable to the Committee, the 
Committee does not anticipate that this rule has any 
significant precedential value in future treaty negotiations. 
If the United States permits residents of third countries to 
claim benefits of one of its treaties, it should only permit 
such derivative benefits in cases where the benefits that a 
third-country resident could claim, under its own treaty with 
the United States, are no less favorable than the ones that are 
available under a derivative benefits article, in order to 
avoid potential abuses.
    Second, the person must be one either who would be a 
``qualifying person'' under the proposed revised protocol if 
the person were a resident of Canada, or who could satisfy an 
active business test. To satisfy the active business test, the 
person must be one who would qualify for benefits under the 
proposed revised protocol's active business test, if that 
person were a resident of Canada and the business it carried on 
in the country of which it is a resident were carried on by it 
in Canada. The active-business test qualifies a person for 
benefits only with respect to certain income: that is, income 
derived in connection with or incidental to that business. The 
Technical Explanation clarifies that the income that is 
relevant for purposes of qualification under this test is the 
same income with respect to which treaty benefits would be 
available by satisfying the requirements of the provision (that 
is, income that is eligible for the reduced rate: interest, 
dividends or royalties). In addition, it is understood that it 
is permissible under the proposed revised protocol for the 
United States to deny treaty benefits to any particular portion 
of the income of the Canadian resident on the ground that 
portion represents income not derived in connection with or 
incidental to the appropriate business.
    In defining ``qualifying person'' for this purpose, the 
language of the proposed revised protocol differs from the 
comparable provision of the Netherlands treaty.\32\ The 
determination of whether a person is a resident of Canada for 
this purpose should be made as if the third country were 
Canada. The Technical Explanation clarifies that the provision 
is intended to apply in this manner.
    \32\ See Article 26(8)(i) of the U.S.-Netherlands tax treaty which 
provides: ``The term `resident of a member state of the European 
Communities' means a person that would be considered a resident of any 
such member state under the principles of Article 4 (Resident) and 
would be entitled to the benefits of this Convention under the 
principles of paragraph 1, applied as if such member state were the 
Netherlands . . .'' (emphasis supplied).
---------------------------------------------------------------------------
    Third, under the treaty between that person's country of 
residence and the United States, the person must be entitled to 
a limitation on the rate of U.S. tax on the particular class of 
income for which benefits are being claimed under the Canadian 
treaty, that is at least as low as the rate applicable under 
the Canadian treaty.\33\
    \33\ See the discussion in Part VI. B. above, relating to 
royalties, for an issue raised by using solely the rate as the 
benchmark for the third requirement.
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Grant of benefits by the competent authority

    Further, like other treaties, the proposed revised protocol 
provides a ``safety-valve,'' under which benefits may be 
provided to a treaty-country resident that has not established 
that it meets one of the other more objective tests. In other 
treaties, particularly in newer treaties and the branch profits 
tax provisions of the Code, such provisions typically provide 
the competent authority with discretion to grant treaty 
benefits. In addition, other treaties sometimes set forth 
guidelines in greater or lesser detail for the competent 
authority's exercise of that discretion.
    The proposed revised protocol provides that where a 
resident of Canada is not entitled under the preceding 
provisions of the limitation on benefits article to U.S. treaty 
benefits, the U.S. competent authority shall, upon that 
person's request, determine whether one of two conditions 
apply. The determination is to be made on the basis of all 
factors including the history, structure, ownership and 
operations of that person. If the competent authority 
determines that either condition applies, then the person is to 
be granted the benefits of the treaty.
    The first condition is that the person's creation and 
existence did not have as a principal purpose the obtaining of 
benefits under the treaty that would not otherwise be 
available. The second condition is that it would not be 
appropriate, having regard to the purpose of the limitation on 
benefits article, to deny the benefits of the treaty to that 
person. The Technical Explanation does not clarify the 
circumstances under which treaty benefits would be granted by 
the competent authority under the second condition.
    There appears to be no comparable provision with precisely 
identical language in this respect. Some earlier treaties, such 
as those with Australia and New Zealand, require treaty 
benefits to be provided if the establishment, acquisition, and 
maintenance of the person, and the conduct of its operations 
did not have as one of its principal purposes the purpose of 
obtaining benefits under the treaty.
    The language of the proposed revised protocol differs from 
that in the German treaty in that the proposed revised protocol 
may require a factor that might otherwise merely be taken into 
consideration to be dispositive. The Committee does not favor 
any interpretation of this provision leading to the result that 
the competent authorities may not have adequate authority to 
deny benefits.\34\ The Committee believes that in future treaty 
negotiations, any provision permitting the grant of treaty 
benefits by the competent authority should be drafted so as 
clearly to permit the competent authorities adequate discretion 
to deny benefits in appropriate circumstances as well.
    \34\ That is, if the competent authority does determine that the 
person's creation and existence did not have as a principal purpose the 
obtaining of benefits under the treaty that would not otherwise be 
available, then the competent authority must grant treaty benefits.
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Anti-abuse rules

    The proposed revised protocol includes a provision, not 
found in any other treaty, that either of the countries may 
deny treaty benefits ``where it can reasonably be concluded 
that to do otherwise would result in an abuse of the provisions 
of the Convention.'' Under this provision, either Canada or the 
United States may apply internal law to deny treaty benefits. 
This is the only limitation on the provision of treaty benefits 
by Canada, whereas it supplements all of the foregoing rules 
for limitation on treaty benefits by the United States. The 
Technical Explanation states that Canada will remain free to 
invoke its applicable anti-avoidance rules to counter abusive 
arrangements involving treaty-shopping through the United 
States, and the United States will remain free to apply its 
substance-over-form and anti-conduit rules, for example, in 
relation to Canadian residents.
            Internal U.S. law
    U.S. courts have stated that the incidence of taxation 
depends upon the substance of a transaction as a whole.\35\ In 
certain cases, courts have recharacterized transactions in 
order to impose tax consistent with this principle. For 
example, where three parties have engaged in a chain of 
transactions, the courts have at times ignored the ``middle'' 
party as a mere ``conduit,'' and imposed tax as if a single 
transaction had been carried out between the parties at the 
ends of the chain.
    \35\ See, e.g., Commissioner v. Court Holding Co., 324 U.S. 331 
(1945).
---------------------------------------------------------------------------
    In Aiken Industries, Inc. v. Commissioner,\36\ the Tax 
Court recharacterized an interest payment by a U.S. person on 
its note held by a related treaty-country resident, which in 
turn had a precisely matching obligation to a related non-
treaty-country resident, as a payment directly by the U.S. 
person to the non-treaty-country resident. The transaction in 
its recharacterized form resulted in a loss of the treaty 
protection that would otherwise have applied on the payment of 
interest by the U.S. person to the treaty-country resident, and 
thus caused the interest payment to give rise to the 30-percent 
U.S. withholding tax.
    \36\ 56 T.C. 925 (1971), acq. on another issue, 1972-2 C.B. 1.
---------------------------------------------------------------------------
    The IRS has taken the position that it will apply a similar 
result in cases where the back-to-back related party debt 
obligations are less closely matched than those in Aiken 
Industries, so long as the intermediary entity does not obtain 
complete dominion and control over the interest payments.\37\ 
The IRS has taken an analogous position where an unrelated 
financial intermediary is interposed between the two related 
parties as lender to one and borrower from the other, as long 
as the intermediary would not have made or maintained the loan 
on the same terms without the corresponding borrowing.\38\ In a 
technical advice memorandum, the IRS has taken the position 
that interest payments by a U.S. company to a related, treaty-
protected financial intermediary may be treated as payments by 
the U.S. company directly to the foreign parent of the 
financial intermediary even though the matching payments from 
the intermediary to the parent are not interest payments, but 
rather are dividends.\39\
    \37\ Rev. Rul. 84-152, 1984-2 C.B. 381; Rev. Rul. 84-153, 1984-2 
C.B. 383.
    \38\ Rev. Rul. 87-89, 1987-2 C.B. 195.
    \39\ Tech. Adv. Mem. 9133004 (May 3, 1991).
---------------------------------------------------------------------------
    A provision of the Code enacted in 1993 expressly 
authorizes the Treasury Secretary to promulgate regulations 
that set forth rules for recharacterizing any multiple-party 
financing transaction as a transaction directly among any two 
or more of such parties where the Secretary determines that 
such recharacterization is appropriate to prevent avoidance of 
any tax imposed by the Code.\40\ The Code authorizes 
regulations that apply not solely to back-to-back loan 
transactions, but also to other financing transactions. For 
example, it is within the proper scope of the provision for the 
Secretary to issue regulations dealing with multiple-party 
transactions involving debt guarantees or equity investments.
    \40\ Code section 7701(l).
---------------------------------------------------------------------------
    Proposed Treasury regulations under this provision 
establish a standard for treating an intermediate entity as a 
conduit. If the intermediate entity is related to the financing 
entity or the financed entity, the financing arrangement 
generally will be subject to recharacterization if (1) the 
participation of the intermediate entity in the financing 
arrangement reduces U.S. withholding tax, and (2) the 
participation of the intermediate entity in the financing 
arrangement is pursuant to a tax avoidance plan. If the 
intermediate entity is unrelated to both the financing entity 
and the financed entity, the financing arrangement generally 
will be subject to recharacterization if the two conditions 
described above are satisfied and, in addition, the 
intermediate entity would not have participated in the 
financing arrangement on substantially the same terms but for 
the fact that the financing entity engaged in the financing 
transaction with the intermediate entity. The proposed 
regulations are intended to provide anti-abuse rules that 
supplement, but do not conflict with, the limitation on 
benefits articles in U.S. income tax treaties. The Committee 
understands that final regulations under this provision are 
likely to be promulgated soon.
            Internal Canadian law
    A general anti-avoidance rule enacted in 1988 provides that 
where a transaction is an avoidance transaction, the tax 
consequences shall be determined as is reasonable under the 
circumstances in order to deny a tax benefit that would 
otherwise result, directly or indirectly, from that transaction 
or from a series of transactions that includes that 
transaction.\41\ The term ``avoidance transaction'' refers to a 
transaction other than one that may reasonably be considered to 
have been undertaken or arranged primarily for bona fide 
purposes other than to obtain the tax benefit.\42\ Tax benefits 
are not to be denied where it may reasonably be considered that 
the transaction would not result directly or indirectly in a 
misuse of the provisions of the Income Tax Act or an abuse 
having regard to the provisions of that Act (other than the 
general anti-avoidance rule), read as a whole.\43\ The terms 
``tax benefit'' and ``tax consequences'' also refer only to 
taxes and related concepts as they are relevant under the 
Income Tax Act. Thus, for example, they may not include treaty 
relief from taxes imposed under the Income Tax Act.
    \41\ Income Tax Act sec. 245(2).
    \42\ Income Tax Act sec. 245(3).
    \43\ Income Tax Act sec. 245(4).
            Additional considerations
    The provision might be considered as not providing 
taxpayers with adequate guidance or certainty, in that it 
relies only on internal Canadian law to determine whether a 
person, otherwise treated as a resident of the United States 
under Article IV of the treaty, is not entitled to treaty 
benefits in Canada due to ``abuse'' of the treaty provisions. 
Legislative or judicial developments could change the substance 
of Canadian tax law as to what constitutes such an abuse. For 
example, a new general income tax anti-avoidance rule was 
enacted in Canada in 1988 which considerably changed the notion 
of abuse and which may be the subject of further interpretation 
or change.44
    \44\ See Arnold, Brian J. and James R. Wilson, ``The General Anti-
Avoidance Rule'' (a 3-part article), 36 Can. Tax J. 829 (Jul.-Aug. 
1988) (part I); 36 Can. Tax J. 1123 (Sep.-Oct. 1988) (part 2); and 36 
Can. Tax J. 1369 (Nov.-Dec. 1988) (part 3).
---------------------------------------------------------------------------
    The Committee notes, nevertheless, that internal rules 
apply in determining treaty-country residents' tax liability, 
and the fact that such rules may change do not necessarily make 
for a weakness in the treaty provisions. This issue is 
addressed in the commentary to the OECD model treaty published 
by the Committee on Fiscal Affairs of the OECD. The commentary 
to Article 1 of the OECD model treaty states that the purpose 
of tax treaties is to promote, by eliminating international 
double taxation, exchanges of goods and services, and the 
movement of capital and persons; and that tax treaties should 
not help tax avoidance or evasion. The OECD model treaty 
contains no anti-abuse provisions, but the commentary discusses 
the types of provisions that treaty negotiators might wish to 
consider. In addition, the commentary mentions internal law 
measures that provide possible ways to deal with abuse of tax 
treaties, such as ``substance-over-form'' rules. The commentary 
indicates a difference of views among representatives of the 
member countries on the Committee of Fiscal Affairs whether or 
not general principles such as ``substance-over-form'' are 
inherent in treaty provisions, i.e., whether they can be 
applied in any case, or only to the extent they are expressly 
mentioned in treaties. The commentary states that it is the 
view of the wide majority of OECD member countries that such 
rules, and the underlying principles, do not have to be 
confirmed in the text of the treaty to be applicable. Where 
these rules are not addressed in tax treaties, the commentary 
indicates a majority view that these rules are not affected by 
the treaties. The commentary also indicates that internal law 
measures designed to counteract abuses should not be applied to 
countries in which taxation is comparable to that of the 
country of residence of the taxpayer.
    Consistent with the majority view expressed in the OECD 
commentary, the Technical Explanation of the proposed revised 
protocol states that the two countries have agreed that the 
principle that each treaty country's applicable anti-abuse 
rules apply in interpreting the proposed revised protocol is 
inherent in the existing treaty. Further, the Technical 
Explanation states that the absence of similar language in 
other treaties is not intended to suggest that the principle it 
expresses is not also inherent in other tax treaties.
    The anti-abuse rule (unlike the rest of the limitation on 
benefits provision of the proposed revised protocol) is 
reciprocal. As a practical matter, however, because of the 
detailed limitation on benefit rules that apply only in the 
case of Canadian residents and the fact that U.S. internal-law 
anti-abuse rules may reach more broadly than Canada's,45 
the provision could be considered lacking in reciprocity. While 
the provisions limiting treaty-shopping through Canada protect 
the U.S. interest in preventing base erosion, the Technical 
Explanation indicates that Canada itself prefers not to utilize 
such rules to prevent treaty shopping through its treaty 
partners.
    \45\ See, e.g., Arnold and Wilson, supra, at 872, 880-882.
---------------------------------------------------------------------------
    The Committee accepts the provision because, given the 
unique preferences of Canada, the Committee understands that 
the provision as proposed does not serve as a precedent, in 
future treaty negotiations, that might interfere in the efforts 
of the United States to maintain a network of anti-treaty-
shopping provisions that adequately protects the U.S. tax base 
as well as the interests of residents of the United States.

                  D. Deductibility of Gambling Losses

    A nonresident alien individual or foreign corporation 
generally is subject to U.S. tax on gross U.S. source gambling 
winnings, collected by withholding. In general, no offsets or 
refunds are allowed for gambling losses (Barba v. United 
States, 2 Cl. Ct. 674 (1983)). On the other hand, a U.S. 
citizen, resident, or corporation may be entitled to deduct 
gambling losses to the extent of gambling winnings (Code sec. 
165(d)). It is understood that Canada does not have a provision 
comparable to Code section 165(d). Instead, an individual is 
subject to tax on income derived from gambling only if the 
gambling activities constitute carrying on a trade or business 
(e.g., the activities of a bookmaker). Whether gambling 
activities rise to the level of a trade or business is 
determined on the facts and circumstances of each case.
    The proposed revised protocol adds a provision not found in 
any other U.S. treaty or the model treaties, permitting a 
resident of either country the benefit of certain gambling 
losses against taxes paid to the other country. As applied to a 
Canadian resident with U.S. tax liability, the Technical 
Explanation indicates that the protocol requires the United 
States to allow a Canadian resident to file a refund claim for 
U.S. tax withheld, to the extent that the tax would be reduced 
by deductions for U.S. gambling losses the Canadian resident 
incurred under the deduction rules that apply to U.S. 
residents. This provision has the practical effect of 
permitting a refund only of U.S. taxes imposed on U.S. gambling 
winnings, while not changing the Canadian tax treatment of 
Canadian gambling winnings (which are generally exempt from 
Canadian tax for a person not engaged in the trade or business 
of gambling).46
    \46\ The ``other income'' provision of most U.S. tax treaties 
permits taxation of income not addressed elsewhere in the treaty (such 
as gambling winnings) only in the country in which the recipient 
resides.
    For example, assume that in 1996, a Canadian resident 
individual has, before reduction for any U.S. taxes withheld, 
$5,000 of U.S. source gambling winnings, $5,000 of non-U.S. 
source gambling winnings, $10,000 of U.S. source portfolio 
dividends, and $7,500 of losses from gambling. All of his 
losses were at wagers that, had he won, would have generated 
U.S. source income. At the end of the year he has borne $3,000 
U.S. tax by withholding, $1,500 of which was imposed on his 
U.S. source gambling winnings. It is understood that the 
proposed revised protocol would authorize a refund of no more 
than $1,500 of U.S. tax.
    It is understood that the provision would not permit a 
Canadian resident who is not engaged in the trade or business 
of gambling, and who has Canadian gambling losses and U.S. 
gambling winnings, to offset the losses and winnings against 
each other for U.S. tax purposes. For example, assume that in 
1996, a Canadian resident individual has, before reduction for 
any U.S. taxes withheld, $15,000 of U.S. source gambling 
winnings and $8,000 of gambling losses from wagers that, had he 
won, would have generated Canadian source winnings. At the end 
of the year he has borne $3,000 U.S. tax by withholding, none 
of which may be refunded under this provision of the proposed 
revised protocol.
    The Committee believes that, on balance, this special 
provision is justified in the context of the proposed revised 
protocol. The Committee's acceptance of this provision in this 
case should not be construed, however, as a general acceptance 
of treaty provisions that accord treaty-partner residents 
favorable U.S. treatment of certain gambling losses without 
significantly changing the treatment of U.S. residents under 
the treaty partner's internal law.

           E. 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 a General Agreement on Trade in Services 
(``GATS''). This agreement generally obligates members (such as 
the United States and Canada) 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, 
decision, 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.
    It is understood that both Canada and the United States 
agree that, in the case of a treaty that is treated as in force 
on January 1, 1995, as discussed above, a protocol to that 
treaty also is treated as in force on January 1, 1995 for 
purposes of the GATS. Nevertheless, inasmuch as the proposed 
revised protocol extends the application of the existing 
treaty, and particularly the nondiscrimination article, to 
additional taxes (e.g., some non-income taxes imposed by 
Canada), the negotiators sought to remove any ambiguity and 
agreed to a provision that clarifies the scope of the treaty 
and the relationship between the treaty and GATS.
    Thus, the proposed revised protocol specifies that for this 
purpose, a measure will fall within the scope of the existing 
treaty (as modified by the proposed revised protocol) if it 
relates to any tax imposed by Canada or the United States, or 
to any other tax to which any part of the treaty applies (e.g., 
a state, provincial, or local tax), but only to the extent that 
the measure relates to a matter dealt with in the treaty. 
Moreover, any doubt about the interpretation of this scope is 
to be resolved between the competent authorities as in any 
other case of difficulty or doubt arising as to the 
interpretation or application of the treaty, or under any other 
procedures agreed to by the two countries.
    This provision of the proposed revised protocol is drafted 
more narrowly than the corresponding provisions of the proposed 
treaties with France, Portugal, and Sweden. It is understood 
that the difference results solely from an effort not to 
interfere with the operation of the North American Free Trade 
Agreement (``NAFTA''), and that the corresponding provisions of 
the proposed treaties with France, Portugal, and Sweden reflect 
the preferred position of the U.S. Treasury Department.
    The Committee believes that it is important that (1) 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 (2) 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). The Committee believes that the provision of the 
proposed treaty is adequate to preclude the preemption of the 
mutual agreement provisions of the proposed treaty by the 
dispute settlement procedures under the GATS.
                      F. Assistance in Collection

    The proposed revised protocol adds a new article to the 
treaty requiring each country to undertake to lend 
administrative assistance to the other in collecting taxes 
covered by the treaty. The assistance provision is 
substantially broader than the most nearly comparable provision 
in the U.S. model treaty or the existing treaty.47
    \47\ Under the existing treaty, similar to the U.S. model treaty 
and other U.S. treaties, each country will endeavor to collect on 
behalf of the other country such amounts as may be necessary to ensure 
that relief granted by the treaty from taxation imposed by that other 
country does not enure to the benefit of persons not entitled thereto 
(Article XXVI(4) (Mutual Agreement Procedure). The proposed revised 
protocol does not alter this provision.
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    The proposed revised protocol provides that the countries 
are to undertake to lend assistance to each other in collecting 
all categories of taxes collected by or on behalf of the 
government of each country, together with interest, costs, 
additions to such taxes and civil penalties. No assistance, 
however, is to be provided under this article for a revenue 
claim with respect to an individual taxpayer to the extent that 
the taxpayer can demonstrate that the claim relates to a 
taxable period in which the taxpayer was a citizen of country 
from which assistance is requested (the ``requested country''). 
Similarly where the taxpayer is a company, estate, or trust, no 
assistance is to be provided under this article for a revenue 
claim to the extent that the taxpayer can demonstrate that the 
claim relates to a taxable period in which the taxpayer derived 
its status as such an entity from the laws in force in the 
requested country. The only collection assistance in such a 
case would be assistance authorized under the existing treaty's 
mutual agreement procedure article.
    When one country applies to the other for assistance in 
enforcing a revenue claim, its application must include a 
certification that the taxes have been finally determined under 
its own laws. For purposes of this article, a revenue claim is 
finally determined when the applicant country has the right 
under its internal law to collect the revenue claim and all 
administrative and judicial rights of the taxpayer to restrain 
collection in the applicant country have lapsed or been 
exhausted.
    The proposed revised protocol specifies that each country 
may accept for collection a revenue claim of the other country 
which has been finally determined. Consistent with this 
language, the Technical Explanation states that each country 
has the discretion whether to accept any particular application 
for collection assistance. If the request is accepted, 
generally the accepting country is to collect the revenue claim 
as though it were its own revenue claim, finally determined in 
accordance with the laws applicable to the collection of its 
own taxes. However, a revenue claim of an applicant country 
accepted for collection will not have, in the requested 
country, any priority accorded to the revenue claims of the 
requested country.
    If the accepting country is the United States, it will 
treat the claim as an assessment under U.S. law against the 
taxpayer as of the time the application is received; if the 
accepting country is Canada, it will treat the claim as an 
amount payable under the Income Tax Act, the collection of 
which is not subject to any restriction.
    Nothing in the assistance in collection article shall be 
construed as creating or providing any rights of administrative 
or judicial review of the applicant country's finally 
determined revenue claim by the requested country, based on any 
such rights that may be available under the laws of either 
country. On the other hand, if, at any time pending execution 
of a request for assistance under this provision, the applicant 
country loses the right under its internal law to collect the 
revenue claim, its competent authority will promptly withdraw 
the request for assistance in collection.
    In general, amounts collected under the assistance in 
collection article are to be forwarded to the competent 
authority of the applicant country. Unless the competent 
authorities otherwise agree, the ordinary costs incurred in 
providing assistance are to be borne by the requested country, 
and any extraordinary costs by the applicant country.
    Nothing in the proposed new article is to be construed as 
requiring either country to carry out administrative measures 
of a different nature from those used in the collection of its 
own taxes, or that would be contrary to its public policy. The 
competent authorities shall agree upon the mode of application 
of the article, including agreement to ensure comparable levels 
of assistance to each country.
    The proposed new article is similar to the provision on 
assistance in recovery of tax claims that is in the Convention 
on Mutual Administrative Assistance in Tax Matters, among the 
member States of the Council of Europe and the OECD.48 The 
Convention entered into force on April 1, 1995. The Convention 
differs from the proposed revised protocol in that it involves 
multiple parties, not two parties; the negotiating 
considerations may have differed from those that were relevant 
in negotiating the proposed revised protocol. The United States 
ratified the Convention subject to a reservation that the 
United States will not provide assistance in the recovery of 
any tax claim, or in the recovery of an administrative fine, 
for any tax.
    \48\ Section II, Articles 11 through 16, Senate Treaty Doc. 101-6, 
November 8, 1989.
    At that time,49 it was pointed out that by entering 
into such a reservation, the United States might forego 
significant benefits. The reservation, could, for example, 
prevent the United States from collecting the maximum amount of 
taxes due it by causing it not to be able to avail itself of 
the collection procedures of another government. On the other 
hand, it was noted that a reservation with respect to this 
issue could be appropriate, in that the United States should 
not be obligated to help another government collect its 
uncontested tax claims against U.S. residents or to collect its 
claims against its own residents.50
    \49\ See Joint Committee on Taxation, ``Explanation of Proposed 
Convention on Mutual Administrative Assistance in Tax Matters'' (JCS-
14-90), June 13, 1990.
    \50\ For example, in 1951, the Senate considered income tax 
treaties for Greece, Norway, and South Africa which, as originally 
submitted to the Senate, would have obligated the treaty countries to 
provide broad tax collection assistance to each other. The Senate gave 
its advice and consent to those treaties subject to an understanding 
that the countries would only provide such collection assistance as 
would be necessary to ensure that the exemption or reduced rate of tax 
granted by the treaties would not be enjoyed by persons not entitled to 
those benefits.
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    The Committee believes that, because of the special and 
unusually compatible relationship between the United States and 
Canada, inclusion of this provision in the proposed revised 
protocol is justified. Inclusion of the assistance in 
collection provision in the proposed Canadian protocol may lead 
to increased interest in the inclusion of similar provisions in 
protocols or treaties with other governments. In each instance, 
consideration may need to be given as to whether it is 
appropriate for the United States to assist in the collection 
of another government's taxes. This analysis may involve an 
evaluation of both the substantive and procedural elements of 
the other government's taxes, as well as an analysis of broader 
policy issues, such as the relative compatibility of the other 
government's legal systems and individual protection with those 
of the United States.

              G. Arbitration of Competent Authority Issues

    In a step that has been taken only recently in U.S. income 
tax treaties (i.e., beginning with the 1989 income tax treaty 
between the United States and Germany and the 1992 income tax 
treaties between the United States and the Netherlands), the 
proposed treaty delegates to the executive branch the power to 
enter into an agreement under which a binding arbitration 
procedure may be invoked, if both competent authorities and the 
taxpayers involved agree, for the resolution of those disputes 
in the interpretation or application of the treaty that it is 
within the jurisdiction of the competent authorities to 
resolve. This provision is effective only after diplomatic 
notes are exchanged between Canada and the United States. 
Consultation between the two countries regarding whether such 
an exchange of notes should occur will take place after a 
period of three years after the proposed treaty has entered 
into force.
    Generally, the jurisdiction of the competent authorities 
under the proposed treaty is as broad as it is under any U.S. 
income tax treaties. Specifically, the competent authorities 
are required to resolve by mutual agreement any difficulties or 
doubts arising as to the interpretation or application of the 
treaty. They may also consult together regarding cases not 
provided for in the treaty.
    As an initial matter, it is necessary to recognize that 
there are appropriate limits to the competent authorities' own 
scope of review.51 The competent authorities would not 
properly agree to be bound by an arbitration decision that 
purported to decide issues that the competent authorities would 
not agree to decide themselves. Even within the bounds of the 
competent authorities' decision-making power, there likely will 
be issues that one or the other competent authority will not 
agree to put in the hands of arbitrators. Consistent with these 
principles, the Technical Explanation expects that the 
arbitration procedures will ensure that the competent 
authorities would not accede to arbitration with respect to 
matters concerning the tax policy or domestic tax law of either 
treaty country.
    \51\ In discussing a clause permitting the competent authorities to 
eliminate double taxation in cases not provided for in the treaty, 
Representative Dan Rostenkowski, then Chairman of the House Committee 
on Ways and Means, submitted the following testimony in 1981 hearings 
before the Senate Committee on Foreign Relations:

      Under a literal reading, this delegation could be 
      interpreted to include double taxation arising from any 
      source, even state unitary tax systems. Accordingly, the 
      scope of this delegation of authority must be clarified and 
      limited to include only noncontroversial technical matters, 
---------------------------------------------------------------------------
      not items of substance.

``Tax Treaties: Hearings on Various Tax Treaties Before the Senate 
Committee on Foreign Relations,'' 97th Cong., 1st Sess. 58 (1981).
    As stated in recommending ratification of the U.S.-Germany 
treaty and the U.S.-Netherlands treaty, the Committee still 
believes that the tax system potentially may have much to gain 
from use of a procedure, such as arbitration, in which 
independent experts can resolve disputes that otherwise may 
impede efficient administration of the tax laws. However, the 
Committee believes that the appropriateness of such a clause in 
a treaty depends strongly on the other party to the treaty, and 
the experience that the competent authorities have under the 
corresponding provision in the German and Netherlands treaties. 
The Committee understands that to date there have been no 
arbitrations of competent authority cases under the German 
treaty or the Netherlands treaty, and few tax arbitrations 
outside the context of those treaties. The Committee believes 
that the negotiators acted appropriately in conditioning the 
effectiveness of this provision on the outcome of future 
developments in this evolving area of international tax 
administration.

 H. Effect of Subsequent Legislation on Implementation of the Protocol
    The proposed revised protocol contains a provision that 
requires the appropriate authorities to consult on appropriate 
future changes to the treaty whenever the internal law of one 
of the treaty countries is changed in a way that unilaterally 
removes or significantly limits any material benefit otherwise 
provided under the treaty. When a treaty partner's internal tax 
laws and policies change, it may be desirable that treaty 
provisions designed and bargained to coordinate the predecessor 
laws and policies be reviewed to determine how those provisions 
apply under the changed circumstances. There are cases where 
giving continued effect to a particular treaty provision does 
not conflict with the policy of a particular statutory change. 
In certain other cases, however, a mismatch between an existing 
treaty provision and a newly-enacted law may exist, in which 
case the continued effect of the treaty provision may frustrate 
the policy of the new internal law. In some cases the continued 
effect of the existing treaty provision would be to give an 
unbargained-for benefit to taxpayers or one of the treaty 
partners, especially if changes in taxpayer behavior result in 
a treaty being used in a way that was not anticipated when the 
original bargain was struck. At that point, the treaty 
provision in question may no longer eliminate double taxation 
or prevent fiscal evasion; if not, its intended purpose would 
no longer be served.52 Strict adherence to all existing 
treaty provisions pending bilateral agreement on changes may 
impose significant limitations on the implementation of desired 
tax policy. Termination of the entire treaty may not be a 
desirable alternative.
    \52\ See the discussion of the Senate Committee on Finance's view 
on this subject in Sen. Rept. No. 100-445, 100th Cong., 2d Sess. at 323 
(1988) (relating to a provision that would have modified the 1954 
transition rule in Code sec. 7852(d) governing the relationship between 
treaties and the Code, to clarify that it does not prevent application 
of the general rule providing that the later in time of a statute or a 
treaty controls).
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    While the Committee agrees that attempts to resolve tax 
treaty abuse problems should be carried out on a bilateral 
basis, where resolution by that route is timely and otherwise 
practical, the Committee believes that obligations under a 
treaty or protocol should not be permitted to impinge on 
Congress' power to lay and collect taxes, nor should they be 
interpreted to preclude changes in U.S. domestic tax policy. 
The Committee wishes to clarify that, in recommending that the 
Senate give advice and consent to ratification of the proposed 
revised protocol, the Committee understands that this consent 
in no way alters the constitutional prerogatives of the 
Congress.

                           VII. Budget Impact

    The Committee has been informed by the staff of the Joint 
Committee on Taxation that the proposed revised protocol is 
estimated to increase Federal budget receipts by less than $50 
million annually during the fiscal year 1995-2000 period.

            VIII. Explanation of Revised Protocol Provisions

    For a detailed, article-by-article explanation of the 
proposed revised protocol, see the ``Treasury Department 
Technical Explanation of the Protocol Amending the Convention 
Between the United States of America and Canada With Respect to 
Taxes on Income and on Capital Signed at Washington on 
September 26, 1980, as Amended by the Protocols Signed on June 
14, 1983 and March 28, 1984.''

               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 a Revised Protocol Amending the Convention 
between the United States and Canada with Respect to Taxes on 
Income and on Capital signed at Washington on September 26, 
1980, as Amended by the Protocols signed on June 14, 1983 and 
March 28, 1984. The Revised Protocol was signed at Washington 
on March 17, 1995 (Treaty Doc. 104-4). The Senate's advice and 
consent is subject to the following declaration, which shall 
not be included in the instrument of ratification to be signed 
by the President:
          That the United States Department of the Treasury 
        shall inform the Senate Committee on Foreign Relations 
        as to the progress of all negotiations with and actions 
        taken by Canada that may affect the application of 
        paragraph 3(d) of article XII of the Convention, as 
        amended by article 7 of the proposed Protocol.