terprise that is a resident of one country is not taxable by the other country on its business profits unless those profits are attributable to a permanent establishment of the resident in the other country. In addition, the permanent establishment concept is used to determine whether the reduced rates of, or exemptions from, tax provided for dividends, interest, and royalties will apply, or whether those amounts will be taxed as business profits. Taxation of business profits is discussed under Article 7 (Business Profits).

In general, under the proposed treaty, a permanent establishment is a fixed place of business through which an enterprise engages in business. A permanent establishment includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, or other place of extraction of natural resources. It also includes any building site or construction, assembly, or installation project, if the site or project lasts for more than 12 months. The 12-month period for establishing a permanent estab lishment in connection with a site or project corresponds to the rule of the U.S. model treaty.

The general rule is modified to provide that a fixed place of business that is used for any of a number of specified activities will not constitute a permanent establishment. These activities include the use of facilities solely for storing, displaying, or delivering merchandise belonging to the enterprise and the maintenance of a stock of goods belonging to the enterprise solely for storage, display, or delivery, or solely for processing by another enterprise. These activities also include the maintenance of a fixed place of business solely for the purchase of goods or merchandise or for the collection of information for the enterprise; this specification is part of the U.S. model but is new in relation to the present German treaty. These activities include as well the maintenance of a fixed place of business solely for the purpose of advertising, of the supply of information, of scientific activities, or of similar activities for the enterprise that have a preparatory or auxiliary character; this specification is part of the present German treaty but is not found in the U.S. or OECD models.

Under the U.S. model treaty, the maintenance of a fixed place of business solely for any combination of these activities will not constitute a permanent establishment. Under the proposed treaty, a fixed place of business used solely for any combination of these activities will not constitute a permanent establishment, provided that the overall activity of the fixed place of business is of a preparatory or auxiliary character. Neither clause appears in the present German treaty.

If a person has, and habitually exercises, the authority to conclude contracts in a country on behalf of an enterprise of the other country, then the enterprise generally will be deemed to have a permanent establishment in the first country. Consistent with the model treaties, this rule does not apply where the contracting authority is limited to those activities (described above) such as storage, display, or delivery of merchandise which are excluded from the definition of permanent establishment. Under the present treaty this exception only applies where the exercise of authority is limited to the purchase of goods or merchandise for the account of the enterprise. The proposed treaty contains the usual provision

that the agency rule will not apply if the agent is a broker, general commission agent, or any other agent of independent status acting in the ordinary course of its business.

The determination whether a company of one country has a permanent establishment in the other country is to be made without regard to the fact that the company may be related to a company that is a resident of the other country or to a company that engages in business in that other country. Such relationships are thus not relevant; only the activities of the company being tested are relevant.

The permanent establishment article is modified by paragraph 3 of the proposed protocol, under which a resident of one country that performs in the other country concerts, theatrical or artistic performances, or similar shows and revues and that may not be taxed in the performance country under the provisions of Article 17 (Artistes and Athletes) shall not be deemed to have a permanent establishment in the performance country if its presence does not exceed in the aggregate 183 days in the calendar year concerned.

ARTICLE 6. INCOME FROM IMMOVABLE (REAL) PROPERTY

This article covers income from "immovable" (or for U.S. purposes, real) property. The rules covering gains from the sale of immovable property are in Article 13.

Under the proposed treaty, income derived by a resident of one country from immovable property situated in the other country may be taxed in the country where the immovable property is located. Income from immovable property includes income from agriculture or forestry.

The term "immovable property" has the meaning which it has under the law of the country in which the property in question is situated. For property situated in the United States, the term means "real property" as defined by U.S. law. The term in any case includes property accessory to immovable property; livestock and equipment used in agriculture and forestry; rights to which the provisions of general law respecting landed property apply; usufruct of immovable property; and rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits, sources, and other natural resources. Thus, income from immovable property includes royalties and other payments in respect of the exploitation of natural resources (e.g., oil). It does not include interest on loans secured by real property. Ships and aircraft are not real property.

The source country may tax income derived from the direct use, letting, or use in any other form of immovable property. These rules allowing source country taxation also apply to the income from immovable property of an enterprise and to income from immovable property used for the performance of independent personal services.

The present treaty, the U.S. model treaty, and certain other U.S. income tax treaties provide residents of one country with an election to be taxed on a net basis by the other country on income from real property in that other country. The proposed treaty does not contain that election, but a net basis election is provided for U.S.

real property income under the Code (secs. 871(d) and 882(d)). The Committee understands that Germany also provides for taxation of income from immovable property on a net basis.

U.S. Code rules

ARTICLE 7. BUSINESS PROFITS

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 persons, only three types of foreign source income can be effectively connected income: rents and royalties derived from the active conduct of a licensing business; dividends and interest either 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 its U.S. business. 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 world-wide 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 ac

tivities 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 is not generally taxed as business income. However, this rule generally does not apply to a dealer, or, in the case of trading in stocks or securities, to a corporation the principal business of which is trading in stocks or securities for its own account, if its principal office is in the United States.

The Code as amended by the Tax Reform Act of 1986 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 an enterprise of one country are taxable in the other country only to the extent that they are attributable to a permanent establishment in the other country through which the enterprise carries on business. This is one of the basic limitations on a country's right to tax income of a resident of the other country.

The taxation of business profits under the proposed treaty differs from 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 an "attributable to" standard for the Code's "effectively connected" standard. Under the Code, all that is necessary for effectively connected business profits to be taxed is that a trade or business be carried on in the United States. Profits from U.S. source income other than U.S. source periodic income (such as interest, dividends, rents, and wages), and U.S. source capital gains, are treated as effectively connected with the conduct of a trade or business in the United States, and taxed as such by the United States, without regard to whether they were derived from business activities or business assets. Under the proposed treaty, by contrast, some level of fixed place of business must be present and the business profits must be attributable to that fixed place of business.

The business profits of a permanent establishment are determined on an arm's length basis. Thus, there are to be attributed to a permanent establishment the business profits which would reasonably be expected to have been derived by it if it were a distinct and independent entity engaged in the same or similar activities under the same or similar conditions. For example, this arm's length rule applies to transactions between the permanent estab

lishment and a branch of the resident enterprise located in a third country. Amounts may be attributed to the permanent establishment whether they are from sources within or without the country in which the permanent establishment is located.

In computing taxable business profits, deductions are allowed for expenses, wherever incurred, which are incurred for the purposes of the permanent establishment. These deductions include a reasonable amount of executive and general administrative expenses, research and development expenses, interest, and other similar expenses. Under this language, which differs in minor respects from the U.S. model, the Committee understands that, as indicated by Treasury in its Technical Explanation, the United States is currently free to use its expense allocation rules in determining the reasonable amount. Thus, for example, a German company which has a branch office in the United States but which has its head office in Germany will, in computing the U.S. tax liability of the branch, be entitled to deduct a portion of the executive and general administrative expenses incurred in Germany by the head office, allocated and apportioned in accordance with Treas. Reg. sec. 1.861-8, for purposes of operating the U.S. branch. However, under paragraph 6 of the proposed protocol, the U.S. and German competent authorities may mutually agree to common procedures different from those under national law for the allocation to a permanent establishment of such expenses.

Business profits will not be attributed to a permanent establishment merely by reason of the purchase of merchandise by a permanent establishment for the account of the enterprise. Thus, where a permanent establishment purchases goods for its head office, the business profits attributed to the permanent establishment with respect to its other activities will not be increased by a profit element in its purchasing activities.

Neither the proposed treaty nor the present treaty contain the language of the U.S. model and many existing treaties, under which the amount of profits attributable to a permanent establishment must be determined by the same method each year unless there is good and sufficient reason to change the method. However, the Committee understands that this does not give taxpayers any right to take inconsistent positions from year to year that would be impermissible under the model treaty language.

The present treaty contains a "force of attraction rule" similar to, but broader than, the force of attraction rule contained in the Code as described above. Under the present treaty, an enterprise of one country is taxable by the other country both on industrial or commercial profits actually derived and deemed to be derived through a permanent establishment in the other country. The proposed treaty eliminates this rule, providing instead that the business profits to be attributed to the permanent establishment shall include only the profits derived from the assets or activities of the permanent establishment. Thus, the proposed treaty not only departs from the present treaty but also from the more limited force of attraction rule in the Code. The proposed treaty is consistent with the model treaties and other existing U.S. treaties in this respect.