The proposed treaty provides a special rule for the determination of the existence of a permanent establishment in the case of companies engaged in insurance activities. Generally, if an insurance company that is a resident of one of the countries earns premiums from, or insures risks in, the other country, then it is considered to have a permanent establishment in that other country. This general rule does not apply to reinsurance contracts or in cases where the insurance is provided through a broker, general commission agent, or any other independent agent located in the other country and acting in the ordinary course of business.

ARTICLE 6. INCOME FROM IMMOVABLE (REAL) PROPERTY

The proposed treaty provides that income from immovable (i.e., real) property, including income in respect of the operation of mines, oil or gas wells, quarries, or other natural resources, and gains derived from the sale, exchange, or other disposition of such property or of the right giving rise to such income, may be taxed by the country in which the immovable property or natural resource is situated. For purposes of the United States, this rule includes, where applicable, the branch-level taxes imposed under Code section 884. Additional rules regarding the taxation of dispositions of immovable property are provided in the article on capital gains (Article 14).

Interest on indebtedness secured by immovable property or secured by a right giving rise to income in respect of the exploitation of natural resources is not regarded as income from immovable property. Such amounts are subject to the provisions of the article on interest (Article 12). Income derived from the usufruct, direct use, letting, or use in any other form of real property is regarded as income from immovable property. The provisions of this article are applicable to the income from immovable property of an enterprise, as well as to such income used for the performance of independent personal services, even in the absence of a permanent establishment.

Although an election to compute tax on income from immovable property on a net basis is often included in U.S. tax treaties (and is included in the U.S. model treaty), no such election is provided for in the proposed treaty. The Committee understands that the internal laws of both the United States and Indonesia generally provide for net-basis taxation of such income, however.

Immovable property income may also be taxed by the country of residence. In such a case, residence-country taxation is subject to relief from double taxation (Article 23).

ARTICLE 7. SOURCE OF INCOME

The proposed treaty contains a comprehensive set of rules, similar to rules found in certain other U.S. tax treaties, to determine the proper source of income. Source rules are provided for eight different types of income. These rules are relevant in determining whether one of the countries may assert jurisdiction to tax the income on the basis that the income arose within that country. The rules are also relevant to a determination of the appropriate foreign tax credit allowed under the proposed treaty (Article 23). The

U.S. model treaty contains source rules for the foreign tax credit and interest provisions only; local law determines the source of income in other cases under the model.

Under the proposed treaty, dividends paid by a U.S. corporation are U.S. source, and dividends paid by a Indonesian corporation are Indonesian source.

Interest paid by a governmental authority or resident of one of the countries generally is sourced in that country. However, if the interest expense is borne (i.e., deducted) by a permanent establishment of the payor in one of the countries, the interest is sourced in the country in which the permanent establishment is located, even if the payor of the interest is not a resident of either of the countries. Thus, for example, this rule treats as U.S. source income, interest paid (and deducted) by the U.S. branch of a bank organized in a country other than the United States or Indonesia.

Royalties (as defined in Article 13) for the use of, or the right to use, property or rights within one of the countries are sourced in that country.

Income from immovable (real) property (as defined in Article 6) is treated as income from the country in which the immovable property which gives rise to the income is situated.

Rentals from tangible personal (movable) property, except for rentals of ships, aircraft, or containers used in international traffic, are sourced in the country where the property producing the income is used. Rental income from ships, aircraft, or containers used in international traffic is either taxable only in the state of residence as set forth in the article on shipping and air transport (Article 9), or is defined as royalty income (Article 13) and sourced according to the royalty sourcing provisions previously detailed.

Income (including pensions) from personal services generally is sourced in the country where the services are performed. However, income from personal services performed aboard ships or aircraft operated by a resident of one country in international traffic is treated as income from sources within that country if rendered by a member of the regular complement of the ship or aircraft. Social security payments (Article 22) are sourced within a country only if paid by or from public funds of that country (or one of its political subdivisions or local authorities).

Income from the purchase and sale of a real property interest is sourced in the country in which the real property is located or deemed located.

Any of these source rules may be overridden if the income consists of industrial or commercial profits which are attributable to a permanent establishment which the recipient, a resident of one of the countries, has in the other country. In such case the income is sourced in the country in which the permanent establishment is located. This source rule applies to income from real property and natural resources, dividends, interest, royalties, and capital gains, as well as to other industrial and commercial profits, but only, in each case, if the property or rights giving rise to the income are effectively connected with the permanent establishment. Article 8 (Business Profits) sets forth factors to be taken into account in determining whether property or rights giving rise to income are "ef

fectively connected" with a permanent establishment for treaty purposes.

Some of the proposed treaty's source rules differ somewhat from those of the Code. Under Article 28 (General Rules of Taxation), the proposed treaty only applies to benefit taxpayers; thus, a taxpayer is not required to apply a treaty source rule in determining its U.S. tax liability if the corresponding Code source rule would produce a more favorable result. A taxpayer may not, however, make inconsistent choices between the Code and treaty source rules. See Rev. Rul. 84-17, 1984-1 C.B. 308 (applying a similar rule under the Polish income tax treaty).

If the source of any item of income is not covered by the proposed treaty rules, each country will determine the source according to its own law. If the two countries apply different rules, however, or if the source is not readily determinable under the laws of one country, the competent authorities of the two countries may establish a common source for the item of income for purposes of the proposed treaty.

ARTICLE 8. BUSINESS PROFITS

United States Code rules

U.S. law distinguishes between the business income and the investment income of a nonresident alien or foreign corporation. A nonresident alien or foreign corporation is subject to a flat 30-percent rate (or lower treaty rate) of tax on certain U.S. source income if that income is not effectively connected with the conduct of a trade or business within the United States. The regular individual or corporate rates apply to income (from any source) which is effectively connected with the conduct of a trade or business within the United States.

The taxation of income as business or investment income varies depending upon whether the income is U.S. or foreign. In general, U.S. source periodic income (such as interest, dividends, rents, and wages) and U.S. source capital gains are effectively connected with the conduct of a trade or business within the United States only if the asset generating the income is used in or held for use in the conduct of the trade or business, or if the activities of the trade or business were a material factor in the realization of the income. All other U.S. source income of a person engaged in a trade or business in the United States is treated as effectively connected with the conduct of a trade or business in the United States (thus, it is said to be taxed as if it were business income under a limited "force of attraction" rule).

In the case of foreign persons other than insurance companies, foreign source income is effectively connected income only if the foreign person has an office or other fixed place of business in the United States and the income is attributable to that place of business. For such purposes, only three types of foreign source income can be effectively connected income: rents and royalties on intangible property derived from the active conduct of a licensing business; dividends and interest, derived in the active conduct of a banking, financing, or similar business in the United States, (or received by a corporation the principal business of which is trading

in stocks or securities for its own account); and certain sales income attributable to a U.S. sales office.

The foreign source income of a foreign corporation that is subject to tax under the insurance company provisions of the Code may be treated as U.S.-effectively connected without regard to the foregoing rules, so long as such income is attributable to the U.S. business of the foreign corporation. In addition, the net investment income of such a company which must be treated as effectively connected with the conduct of an insurance business within the United States is not less than an amount based on a combination of asset/liability ratios and rates of return on investments experienced by the foreign person in its worldwide operations and by the U.S. insurance industry.

Trading in stocks, securities, or commodities in the United States for one's own account generally does not constitute a trade or business in the United States, and accordingly, income from those activities is not taxed by the United States as business income. Thus, income from trading through a U.S.-based employee, a resident broker, commission agent, custodian, or other agent, or from trading by a foreign person physically present in the United States generally is not taxed as business income. However, this rule does not apply to a dealer or to a corporation the principal business of which is trading in stocks or securities for its own account.

The Code, as amended by the 1986 Act, provides that any income or gain of a foreign person for any taxable year which is attributable to a transaction in any other taxable year will be treated as effectively connected with the conduct of a U.S. trade or business if it would have been so treated had it been taken into account in that other taxable year (Code sec. 864(c)(6)). In addition, the Code provides that if any property ceases to be used or held for use in connection with the conduct of a trade or business within the United States, the determination of whether any income or gain attributable to a sale or exchange of that property occurring within 10 years after the cessation of business is effectively connected with the conduct of trade or business within the United States shall be made as if the sale or exchange occurred immediately before the cessation of business (Code sec. 864(c)(7)).

Proposed treaty rules

Under the proposed treaty, business profits of a person that is a resident of one country are taxable in the other country only if the person carries on business through a permanent establishment situated in the other country. This is one of the basic limitations on a country's right to tax income of a resident of the other country. The proposed treaty's rules on business profits follow, in some respects, the provisions of the U.S. model treaty, with exceptions noted below.

The taxation of business profits under the proposed treaty differs from internal U.S. rules for taxing business profits primarily by requiring more than merely being engaged in a trade or business before a country can tax business profits, and by substituting a different limited force of attraction principle for the Code principle discussed above. Under the proposed treaty, some type of fixed place of business generally must be present in the treaty country.

In addition, the business profits must either be attributable to that fixed place of business or be derived from sources within the treaty country from sales of goods or merchandise of the same kind as those sold (or from other business transactions of the same kinds as those effected) through the permanent establishment.

The proposed treaty does not contain a provision that would permit a country to tax profits and income that are attributable to a resident of the other country's permanent establishment or fixed base located, during its existence, in first country, if the payments of such profits or income are deferred until the permanent establishment or fixed base has ceased to exist. Thus, the proposed treaty does not permit the United States to tax profits under Code section 864(c)(6).

The business profits of a permanent establishment are determined on an arm's-length basis. Thus, there is attributed to a permanent establishment the business profits which might be expected to have been derived by it if it were an independent entity engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with its home office. For example, this arm's-length rule applies to transactions between a taxpayer's permanent establishment and an office of the taxpayer located in a third country. Amounts may be attributed whether they are from sources within or without the country in which the permanent establishment is located.

In computing taxable business profits, deductions generally are allowed under paragraph 3 of Article 8 for expenses, wherever incurred, that are incurred for the purposes of the permanent establishment. These deductions include a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses to the extent that such amounts are reasonably connected with the profits of the permanent establishment. Thus, for example, a U.S. company that has a branch office in Indonesia but its head office in the United States is, in computing the Indonesian tax liability of the branch, entitled to deduct a portion of the executive and general administrative expenses incurred in the United States by the head office for purposes of administering the branch. No such deduction, however, is allowed for amounts paid by the permanent establishment to the head office (or any other of its offices), by way of royalties, fees, or other similar payments for the use of patents or other rights. Additionally, no such deduction is allowed for payments made by the permanent establishment to such parties as commissions for specific services performed, as fees for management, or as interest on funds loaned to the permanent establishment. Similarly, payments of the types specified above, if made by the home office (or any other office) to the permanent establishment are disregarded by the permanent establishment in computing its profits unless such amounts represent reimbursements for actual expenditures incurred by the permanent establishment on behalf of the home office or such other offices.

Business profits are not attributed to a permanent establishment merely by reason of the purchase of merchandise by the permanent establishment for the account of the person of which it is a permanent establishment. Thus, if a permanent establishment purchases