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On March 30, 2004, the Governments of the United States and Japan exchanged instruments of ratification for the income tax treaty signed by the two countries on November 6, 2003 (the "Treaty"). The Treaty, and an accompanying Protocol, replaces the income tax treaty between the two countries which entered into force on July 9, 1972. The quick ratification of the Treaty by the two countries allows the new withholding provisions of the Treaty to take effect on July 1 of this year; if the exchange had occurred after March 31, the new rates would not have taken effect until January 1, 2005. The balance of the provisions of the Treaty will take effect January 1, 2005.

The following is a brief summary of the principal differences between the old treaty and the Treaty.

Dividends

The Treaty generally limits source-country taxation of dividends to 10% of the gross amount of the dividend paid to residents of the other treaty country. A lower rate of 5% will apply if the beneficial owner of the dividend is a company that owns at least 10% of the stock of the dividend-paying company. Both of these rates are lower than under the 1972 treaty, which provided a general withholding rate of 15% and a reduced intercompany rate of 10% in limited circumstances.

In addition, the Treaty provides for a zero withholding rate with respect to dividends paid if the beneficial owner of the dividend is a company that has owned, directly or indirectly, through one or more residents of either contracting state, more than 50% of the voting stock of the dividend paying company for a period of 12 months ending on the date on which entitlement to the dividend is determined. To be entitled to the zero withholding rate, the company receiving the dividend must (1) qualify as "publicly traded" under the Treaty's limitation of benefits article; or (2) satisfy both the "ownership/base erosion" and "active trade or business" tests of the limitation of benefits article; or (3) be granted eligibility by the competent authorities pursuant to the limitation of benefits article. The zero withholding rate will also be available to tax-exempt pension plans provided the dividends are not derived from the carrying on of a business, directly or indirectly, by the fund.

Special rules apply to dividends paid by a United States regulated investment company or real estate investment trust and to their Japanese counterparts.

Branch Profits Tax

Under the 1972 treaty, Japanese corporations with branches in the United States generally were exempt from the branch profits tax. Under the Treaty, the United States may impose the branch profits tax, but at a reduced rate of 5%, on a Japanese corporation that has a permanent establishment in the United States or is subject to tax on a net basis in the United States on income from real property or gains from the disposition of interests in real property. However, the tax will not be imposed in cases where a zero-rate would apply to dividends if the U.S. branch business had been conducted through a separate U.S. subsidiary of the Japanese company.

Interest

The Treaty allows the source country to impose a withholding tax on interest payments. In this regard, the Treaty is similar to the 1972 treaty, but differs from recent treaties negotiated by the United States with other developed countries. The withholding rate is 10%; the same as applicable under the existing treaty.

Under the U.S. Internal Revenue Code (the "Code"), several categories of interest (such as portfolio interest, bank deposit interest and short-term original issue discount) are exempt from withholding. The Treaty provides that it is not to be construed to restrict in any manner any exemption or other allowance now or hereafter accorded under the internal tax laws of the contracting states; thus, a Japanese lender would still be entitled to zero withholding under the provisions of the Code if it met the requirements of the applicable provision.

Notwithstanding the general rule providing for 10% withholding, certain categories of interest are exempt from withholding under the Treaty, including interest beneficially owned by a resident of the other contracting state that is a bank (including an investment bank), an insurance company, a registered securities dealer, certain other depositing-taking entities, and tax-exempt pension funds. In addition, interest paid with respect to indebtedness arising as part of the sale on credit of equipment or merchandise by a resident of the other contracting state is exempt from withholding; this exemption would appear to apply not only to interest received by the seller, but by any holder of the indebtedness resident in the seller's jurisdiction.

The definition of "interest" for purposes of the Treaty includes income from debt claims carrying a right to participate in the debtor's profits; thus, the definition is broader than the Code definition of "interest" for portfolio debt purposes. This differs from normal U.S. treaty practice.

Under the U.S. Internal Revenue Code, tax is payable if a foreign corporation engaged in a trade or business in the United States through a branch (or having gross income treated as effectively connected with the conduct of a trade or business in the United States) allocates interest expense to the United States trade or business which exceeds the actual interest paid by the United States trade or business in the same amount as would be applicable if the U.S. trade or business were a wholly-owned domestic corporation making the interest payment to its parent. Under the Treaty, any such deemed interest payment will be entitled to the same reduction in withholding tax as would apply to an actual payment of interest.

Royalties

The Treaty eliminates withholding taxes on royalties arising in a Treaty country and paid to a resident of the other Treaty country. "Royalties" are broadly defined as any consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work, as well as for the right to use any patent, trademark, design or model, plan, secret formula or process, or other like right or property, or for information concerning industrial, commercial or scientific experience. However, unlike the 1972 treaty, the term does not include gains from the alienation of royalty-producing property where payment is contingent on use. Instead, such gains are dealt with under the Treaty article dealing with gains from the alienation of property, with generally the same effect as the Treaty treatment of royalties; i.e., no tax in the source state. The term "royalties" also does not include income from leasing personal property.

The exemption from source country tax does not apply if the royalties are attributable to a permanent establishment of the recipient in the source country.

In the case of royalties paid between related parties (or parties otherwise having a special relationship), the Treaty provides that the zero withholding rate applies only to the amount of arm's-length royalties. Any amounts paid in excess of arm's-length is taxable in the source country at a rate not to exceed 5%.

The Treaty includes anti-conduit rules which state that a resident of the United States or Japan will not be considered the owner of a royalty in certain "back-to-back" arrangements. The rules are less inclusive that those under existing U.S. law, which will continue to apply.

Fiscally Transparent Entities

One of the more difficult issues under the 1972 treaty was the treatment of income derived by fiscally transparent entities--entities in which income derived by the entity is taxed at the beneficiary, member or participant level. In the United States, this would include partnerships, limited liability companies and revocable trusts. This issue is addressed in detail by the Treaty, which describes five different fact patterns.

Under the first and third cases described in the Treaty, an item of income derived from the U.S. or Japan by an entity that is organized in the other country or a third country and treated as fiscally transparent under the laws of the other country generally will be eligible for Treaty benefits to the same extent such benefits would be granted if the income were directly derived by the beneficiaries, members or participants. For example, if a U.S. limited liability company classified as a partnership for U.S. tax purposes or a Cayman Islands exempted company for which a "check the box" election had been made in the United States to treat the company as a partnership for U.S. tax purposes received dividends from a Japanese company, the dividend would be entitled to the reduced withholding rates under the Treaty to the extent that the dividend would have been eligible for Treaty benefit if received directly by the owners of the limited liability company or the exempted company. Thus, if 60% of the interests of the limited liability company or Cayman Islands exempted company were held by U.S. residents, then 60% of the dividend would be subject to the Treaty withholding rules. If the owners of the remaining 40% of the LLC/Cayman company were residents of a jurisdiction with which Japan had a tax treaty, reduced withholding might apply with respect to the remainder of the dividend to the extent provided under that treaty.

Under the second, fourth and fifth cases described in the Treaty, an item of income derived by an entity organized in any jurisdiction and treated as not fiscally transparent in the contracting state which is not the source state generally will be eligible for the benefits of the Treaty only if the entity is a resident of the non-source state. For example, amounts paid from the U.S. to a Cayman Islands exempted company with Japanese shareholders which has made a U.S. "check the box" election but is still treated as a taxable entity under Japanese law will not be eligible for Treaty benefits. Conversely, a U.S. LLC which has elected to be taxed as a corporation for U.S. tax purposes will be eligible for Treaty benefits with respect to Japanese-source income, provided it otherwise satisfies the limitation of benefits and anti-conduit tests of the Treaty, discussed below, without regard to how the LLC might be characterized under Japanese tax law.

The Treaty does not specifically address the situation where the entity is organized in the contracting state where the item of income arises, and under the laws of the other country the income is considered to be the income of the members, beneficiaries or participants. The Technical Explanation to the Treaty prepared by the Treasury Department indicates that the result in this case will depend on whether the entity is liable to tax in the contracting state in which it is organized. For example, if a U.S. LLC with Japanese members elects to be treated as a corporation for U.S. tax purposes, the U.S. may tax the LLC in its worldwide income on a net basis, in the same manner in which a U.S. corporation would be taxed, even if Japan were to treat the LLC as fiscally transparent. In contrast, if the entity were not subject to tax in the contracting state in which it is organized, and the income of the LLC were treated as the income of its members under both U.S. and Japanese law, then the income would be eligible for Treaty benefits at the entity level to the extent the members were eligible residents of Japan. The Technical Explanation notes that this fact pattern is unlikely to arise in practice because, under the domestic law of Japan, an entity generally either is treated as taxable or is ignored.

The protocol to the Treaty provides specific rules regarding the application of the Treaty to Japanese "sleeping partnerships" (Tokumei Kumiai). In general, these rules allow the two countries to apply their respective domestic tax laws to income derived by and distributions made by such an arrangement. In general, the U.S. will not treat a Tokumei Kumiai as a resident of Japan for Treaty purposes and will not grant Treaty benefits to such an arrangement even if the operator and investor in the arrangement are Japanese residents. The protocol also allows Japan to impose its withholding tax on distributions to the investor even if the investor is a U.S. person.

Stock Options

The protocol to the Treaty provides special rules for the treatment of employee stock option plans to deal with the situations where an employee changes the location of his or her employment after the date of option grant and before option exercise. The annex to the protocol describes four fact patterns and four alternatives under each fact pattern depending upon whether the option is treated as a "qualified" option under the tax laws of either or both countries. In general, the rules are an attempt to assure that the income arising from the option is taxed only once and is fairly apportioned between the two countries, either through the operation of the language of the Treaty and protocol, or through mutual agreement.

Limitation on Benefits

The 1972 treaty did not contain a limitation on benefits ("LOB") article; in keeping with modern U.S. treaty practice, the new Treaty contains an elaborate LOB article. Generally, under the LOB article, a treaty country resident is entitled to all of the benefits of the Treaty only if it is described in one of several specified categories:

• an individual
• certain government entities
• a company that satisfies a public company test and certain subsidiaries of such a company
• certain charitable organizations
• a pension fund that meets an ownership test; and
• an entity that satisfies an ownership test and a base erosion test

A resident that does not fit within one of these categories may claim treaty benefits with respect to certain items of income under an active business test. In addition, a person that does not satisfy any one of these requirements, including the active business test, may be entitled to benefits if the source country's competent authority so determines.

In addition to the LOB article, the Treaty contains anti-conduit rules in the articles dealing with dividends, interest, royalties and "other income" which deny the benefits of the respective article when the legal recipient of the payment would not have acquired the interest in the payment unless a person that is not entitled to the same or more favorable treaty benefits and that is not a resident of either contracting state held an equivalent interest in the resident. As the U.S. already has significant anti-conduit rules under the Internal Revenue Code, these specific rules are more likely to be of importance in Japan.

Transfer Pricing

The Treaty and documents related to the Treaty contain three new provisions affecting transfer pricing audits of U.S. and Japanese companies. The first allows the competent authorities a maximum of seven years from the end of a taxable year in which to begin an audit of a taxpayer's profits, except in cases of fraud, willful default, or if the inability to initiate the examination is attributable to the actions or inaction of the taxpayer. It is unclear what practical impact this provision will have in practice, given the existing three-year statute of limitation on assessments in the United States and the six-year statute in Japan.

The second provision affecting transfer pricing audits is found in letters of agreement exchanged between the U.S. Secretary of State and the Japan Minister of Foreign Affairs. Under the letters of agreement, the parties commit to undertake to conduct transfer pricing examinations and evaluate applications for advance pricing arrangements in accordance with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations of the Organisation for Economic Cooperation and Development (the "OECD Transfer Pricing Guidelines"), and to apply domestic transfer pricing methods only to the extent that they are consistent with the OECD Transfer Pricing Guidelines. The Treasury Department's technical explanation of the Treaty makes clear that the reference to the OECD Transfer Pricing Guidelines is to that document as it evolves, rather than to the current document.

Finally, in the protocol accompanying the Treaty, the parties agree that in evaluating third-party comparables for purpose of determining whether related parties are charging arm's-length prices, five enumerated factors will be considered: (i) the characteristics of the property or services transferred; (ii) functions of the enterprise and the enterprise associated with it, taking into account the assets used and risks assumed by each; (iii) the contractual terms between the enterprise and the associated enterprise; (iv) the economic circumstances of the enterprise and the associated enterprise; and (v) the business strategies pursued by each. Although the protocol provides that the factors to be considered "shall include" the enumerated factors, these are the factors identified in the OECD Transfer Pricing Guidelines.

Other Changes

The Treaty differs from the 1972 treaty in a number of other, less broad-ranging ways. For example, there are changes in the tax treatment of visiting scholars students, and business apprentices, in the taxation of director's fees, in the definition of "United States real property holding corporation" for purposes of taxing gain on the sale of shares of such an entity, and with respect to income from the rental of ships and aircraft. The Treaty also waives the application of the U.S. insurance excise tax on foreign insurers and reinsurers.