goods for its head office, the business profits attributed to the permanent establishment with respect to its other activities are not increased by a profit element in its purchasing activities.

Where business profits include items of income that are dealt with separately in other articles of the proposed treaty, those other articles, and not this article, generally govern the treatment of those items of income.

ARTICLE 9. SHIPPING AND AIR TRANSPORT

As a general rule, the United States taxes the U.S. source income of a foreign person from the operation of ships or aircraft to or from the United States. An exemption from U.S. tax is provided if income is earned by a corporation that is organized in, or an alien individual who is resident in, a foreign country that grants an equivalent exemption to U.S. corporations and residents. The United States has entered into agreements with a number of countries providing reciprocal tax exemptions for shipping and aircraft income.

Under the proposed treaty, income that is derived by a resident of either country from the operation of ships or aircraft in international traffic generally is exempt from tax by the other country. International traffic includes any transportation by ship or aircraft, except transportation solely between places in one of the countries (Article 3(1)(h) (General Definitions)). The exemption applies whether or not the income is attributable to a permanent establishment in one of the countries.

The exemption applies to income from the rental of ships or aircraft in international traffic on a full basis, the rental of aircraft operated in international traffic on a bareboat basis, and the rental of ships operated in international traffic on a bareboat basis unless the lessee of such ship is a resident of, or has a permanent establishment in, the other country. 10 The payments covered by the exception are treated as royalties under the proposed treaty (Article 13). This exception is a departure from the U.S. model, which permits an exemption from source-country tax regardless of whether a ship is operated on a full or bareboat basis, and without consideration of the place of residence (or the existence of a permanent establishment) of the lessee.

In the case of income derived from the use or maintenance of containers (and related equipment for the transportation of containers), and the containers, equipment, etc. are used to transport goods or merchandise in international traffic, the exemption from source-country tax applies only if such income is incidental to income derived from the operation of ships or aircraft in international traffic. Thus, for example, a U.S. company that engages in international shipping operations and earns a relatively minor amount of income from the leasing of containers which are used in international traffic is exempt from Indonesian tax on that income under this article. By contrast, a U.S. company whose sole operation involves the leasing of containers which are used in interna

19 Rental on a full or bareboat basis refers to whether or not the ship or aircraft is leased fully equipped, manned and supplied.

tional transport is not granted the same exemption. Income from such operations is treated as royalty income under the proposed treaty, and to the extent that it is sourced in Indonesia is subject to the provisions of Article 13. This special rule regarding income from container leasing differs from the provision of the U.S. model which treats container leasing income as transportation income, generally taxable only by the residence country.

If a resident of one country derives gain from the disposition of a ship or aircraft which was operated in international traffic, or from the disposition of a container or related equipment necessary for the transport of a container which was used in international traffic, then such gain is only taxable by the country of residence. This provision applies, rather than the provisions of the article on capital gains (Article 14), with respect to such dispositions.

According to the proposed protocol, the two countries have agreed that nothing in the proposed treaty shall prejudice the legal rights of residents of either country to pursue claims concerning the taxation by the other country of income from the operation of ships or aircraft in international traffic for taxable years beginning before the proposed treaty enters into force.

ARTICLE 10. RELATED PERSONS

The proposed treaty, like most other U.S. tax treaties, contains an arm's-length pricing provision similar to section 482 of the Code that recognizes the right of each country to make an allocation of income, deductions, credits, or allowances to that country in the case of transactions between related persons, if an allocation is necessary to reflect the conditions and arrangements that would have been made between independent persons.

For purposes of the proposed treaty, a person is related to another person if either person participates directly or indirectly in the management, control, or capital of the other, or if any third person or persons participates directly or indirectly in the management, control, or capital of both. For this purpose, the term "control" includes any kind of control, whether or not legally enforceable, and however exercised or exercisable.

Where, pursuant to this article, one country includes in the profits of its resident, and taxes accordingly, profits on which a resident of the other country has been subjected to tax in that other country, then that other country, if it agrees that the adjustments made by the first country reflects arm's-length principles, is to make an appropriate adjustment to the amount of the tax charged on its resident on those profits. In determining such adjustment, the other country is to give due regard to the other provisions of the proposed treaty and, if necessary, the competent authorities of the two countries will consult with each other.

The proposed treaty omits the usual treaty provision stating that this article is not intended to limit any law in either country that permits the distribution, apportionment, or allocation of income, deductions, credits, or allowances between non-independent persons if such law is necessary to prevent evasion of taxes or to reflect clearly the income of those persons. That provision generally clarifies that the United States retains the right to apply its intercom

pany pricing rules (Code sec. 482) and its rules relating to the allocation of deductions (Code secs. 861, 862, 863, and 864, and applicable regulations). It is understood by Treasury that the United States retains the right under the proposed treaty to apply its internal intercompany pricing rules, notwithstanding the omission of the standard treaty provision.

In general

ARTICLE 11. DIVIDENDS

This article generally reduces to 15 percent the rate of tax that one of the countries can levy on the gross amount of dividends from sources within that country paid to residents of the other country. The proposed treaty provides that the dividend-recipient's country of residence may also tax the dividend under its internal laws.

U.S. taxation of dividends paid to foreign persons

The United States generally imposes a 30-percent withholding tax on the gross amount of U.S. source dividends paid to nonresident alien individuals and foreign corporations. The 30-percent tax does not apply if the foreign recipient is engaged in a trade or business in the United States and the dividends are effectively connected with that trade or business. In such a case, the foreign recipient is subject to U.S. tax like a U.S. person at the standard graduated rates, on a net basis. For purposes of the 30-percent tax, U.S. source dividends are dividends paid by a U.S. corporation (other than a corporation that has elected status as a possession corporation under Code section 936). Also treated as U.S. source dividends for this purpose are certain dividends paid by a foreign corporation, if at least 25 percent of the gross income of the foreign corporation, in the prior three-year period, was effectively connected with a U.S. trade or business of that foreign corporation. The tax imposed on the latter dividends is often referred to as the "secondlevel" withholding tax.

For taxable years beginning after December 31, 1986, as provided in the 1986 Act, a U.S. branch of a foreign corporation is subject to a branch profits tax in the United States on any deemed repatriation of the branch's U.S. effectively connected earnings and profits. The branch profits tax rate is 30 percent (but can be reduced or eliminated by treaty), and is levied on the branch's dividend equivalent amount. The branch profits tax provision generally replaces the second-level withholding tax (discussed above) which the United States imposed prior to the 1986 Act.

In addition to the branch profits tax, a foreign corporation is also subject to a branch-level interest tax on "excess interest." For this purpose, "excess interest" means the interest deducted by the foreign corporation in computing its U.S. effectively connected income, to the extent that the deduction exceeds the interest paid by the U.S. trade or business. The branch-level tax on excess interest is an amount equal to the tax the foreign corporation would have paid had a wholly owned U.S. corporation paid it an amount of interest equal to the amount of "excess interest."

Indonesian system for taxing dividends

Indonesia generally assesses a 20-percent withholding tax on the gross amount of Indonesian source dividends paid to a nonresident. In addition, a non-Indonesian corporation that has a permanent establishment in Indonesia is subject to a 20-percent withholding tax on its after-tax profits attributable to the permanent establishment (i.e., a branch profits tax). These withholding tax rates have been reduced in certain tax treaties into which Indonesia has entered. Proposed treaty rules

Under the proposed treaty, dividends derived from sources within one of the countries and beneficially owned by a resident of the other country are taxable by both countries; however, the source-country tax may not exceed 15 percent of the gross amount of the dividend actually distributed.

The limitation contained in the proposed treaty on the rate of withholding tax will not apply if the recipient of the dividend has a permanent establishment or fixed base in the source country and the shares with respect to which the dividend is paid are effectively connected with the permanent establishment or fixed base. In that case, the dividend is taxed as business profits (Article 8) or as income from independent personal services (Article 15), as appropriate. In addition, the reduced withholding tax rate does not apply with respect to U.S. source dividends received by U.S. citizens who are resident in Indonesia (Article 28(3)).

Under the proposed treaty, the country in which a corporate resident of the other country has a permanent establishment is authorized to impose a branch profits tax and a branch-level interest tax in accordance with its internal law on the profits attributable to, or interest payments allocable to, the permanent establishment. The rate of the branch-level taxes generally is not to exceed 15 percent. In computing net profits which are subject to a branch profits tax, any company tax and other income taxes imposed by the source country on the income of the permanent establishment are allowed as a deduction.

The proposed protocol clarifies that the United States' branchlevel tax on interest may be imposed on the excess of interest deducted in determining the profits of the permanent establishment over the actual payments of interest by the permanent establishment. Under U.S. law, a permanent establishment is allowed to deduct an allocable portion of the interest expense of its home office. If the deduction exceeds the amount of interest actually paid by the permanent establishment, the excess deduction is treated as if it were remitted to the home office subject to the branch-level interest tax.

In the case of any production-sharing contracts and contracts of work (or any other similar contracts) relating to oil and gas or other mineral products negotiated by the Government of Indonesia, its instrumentality, its relevant State oil company, or any other entity thereof with a person who is a U.S. resident, the rate of branch-level profits or interest taxes is not affected by the provisions of the proposed treaty. In such cases, the Indonesian statutory tax rate of 20 percent applies.

The U.S. model treaty and most recent U.S. income tax treaties define the term "dividends;" the proposed treaty does not. This generally leaves to local law the definition of the term in certain

cases.

ARTICLE 12. INTEREST

Subject to numerous exceptions (such as those for portfolio interest, bank deposit interest, and short term original issue discount), the United States imposes a 30-percent tax on U.S. source interest paid to foreign persons under the same rules that apply to dividends. U.S. source interest, for purposes of the 30-percent tax, generally is interest on the debt obligations of a U.S. person, other than a U.S. person that meets the foreign business requirements of Code section 861(c) (e.g., an 80/20 company). As previously discussed, the United States also imposes a 30-percent branch-level interest tax on excess interest allocable to a U.S. branch of a nonU.S. corporation.

Indonesia generally imposes a withholding tax of 20 percent on interest paid from Indonesian sources to nonresident persons.

As well as allowing a taxpayer's country of residence to tax interest income, the proposed treaty generally allows the imposition of a withholding tax at source on interest. The proposed treaty limits the rate of tax to 15 percent of the gross amount of the interest, however, in situations where the interest is beneficially owned by a resident of the other country. This 15-percent rate contrasts with the U.S. model position, not generally achieved, that interest should be exempt from tax at source.

In cases where interest is derived from sources within one country by the government of the other country or its agency or instrumentality which is exempt from tax in that country, such interest is exempt from source-country tax under the proposed treaty.

As in the case of dividends, if interest is paid on debt that is effectively connected with a permanent establishment or fixed base in the source country, the interest is taxed as business profits (Article 8) or as income from independent personal services (Article 15), as the case may be. That is, the 15-percent rate limitation and exemptions of this article do not apply. In addition, the reduced withholding tax rate does not apply with respect to U.S. source interest received by U.S. citizens who are resident in Indonesia (Article 28(3)).

The proposed treaty addresses the issue of interest charges between related parties that are not at arm's-length by providing that the amount of interest for purposes of applying this article is the amount of arm's-length interest. Where any amount designated as interest paid by a person to any related person (Article 10) exceeds an amount which would have been paid to an unrelated person, the proposed treaty's interest provisions apply only to so much of the interest as would have been paid to an unrelated person. The excess payment may be taxed by each country according to its own law, including the other provisions of the proposed treaty where applicable. For example, excess interest paid to a parent corporation might be treated as a dividend under local law