Guidance Regarding Claims for Certain
Income Tax Convention Benefits

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8889] RIN 1545-AV10

TITLE: Guidance Regarding Claims for Certain Income Tax Convention
Benefits

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to treaty
withholding rates for items of income received by entities that are
fiscally transparent in the United States and/or a foreign
jurisdiction. The regulations affect the determination of tax treaty
benefits available to foreign persons with respect to such items of
income. DATES: Effective Dates: These regulations are effective June
30, 2000. Applicability Dates: These regulations apply to items of
income paid on or after June 30, 2000.

FOR FURTHER INFORMATION CONTACT: Shawn R. Pringle, (202) 622-3850
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains final regulations relating to the Income Tax
Regulations (CFR part 1) under section 894 of the Internal Revenue
Code (Code). On June 30, 1997, the IRS and Treasury issued temporary
regulations (TD 8722 [1997-2 C.B. 81]) in the Federal Register (62
FR 35673, as corrected at 62 FR 46876, 46877) under section 894 of
the Code relating to eligibility for benefits under income tax
treaties for payments to entities. A notice of proposed rulemaking
([1997-2 C.B. 646]) cross-referencing the temporary regulations was
also published in the same issue of the Federal Register (62 FR
35755).

Need for Changes

Since the publication of TD 8722 and proposed regulation §1.894(d)
(REG-104893-97, 62 FR 35755), the IRS and Treasury have received
numerous comments. This Treasury decision contains changes made in
response to some of those comments.

Explanation of Provisions

I. General

These final section 894 regulations clarify the availability of
treaty benefits with respect to an item of U.S. source income paid
to an entity that is treated as fiscally transparent under the laws
of one or more jurisdictions (including the United States) with
respect to that item of income. An entity that is treated as
fiscally transparent in one jurisdiction but not another is referred
to as a hybrid entity. If an item of U.S. source income is paid to a
hybrid entity, the United States may regard the entity as fiscally
transparent with respect to the item of income and the foreign
treaty jurisdiction may regard the entity as deriving the item of
income. Alternatively, the United States may regard the entity as
deriving the item of income under U.S. tax principles, but a foreign
treaty jurisdiction may regard the entity as fiscally transparent
and may therefore regard the interest holders as deriving the item
of income. This dual classification may give rise to inappropriate
and unintended results under tax treaties, such as double non-
taxation or double taxation of the item of income, unless the tax
treaties are interpreted to resolve the conflict of laws.

These final regulations clarify how to apply U.S. treaties when the
entity classification law of the United States and a foreign treaty
jurisdiction conflict by providing that a reduced treaty rate for an
item of U.S. source income is available only if the income is
derived by a foreign recipient resident in the applicable treaty
jurisdiction. This general rule, which has been simplified but not
substantially changed from the rule contained in the temporary and
proposed section 894 regulations, is discussed in greater detail
below.

These final regulations are fully consistent with existing U.S.
treaties. They rely on the basic principle that tax treaties are
intended to relieve double taxation or excessive taxation.
Accordingly, the United States and its treaty partners agree to cede
part or all of their taxation rights on income arising from sources
within their respective borders on the mutual understanding that the
other party is asserting tax jurisdiction over the items of income.
This objective is generally achieved through treaty provisions that
limit or eliminate the tax that the source state may impose on
income arising within its borders to the extent that the income is
considered to be derived by a resident of the other jurisdiction. In
general, an item of income will be considered derived by a resident
for treaty purposes only when the residence country is asserting
taxing jurisdiction over the item of income. However, the source
state does not necessarily require, as a condition for ceding its
taxing jurisdiction, that the income actually be taxed in the
residence state or taxed at a rate commensurate with the rate
imposed in the source state. The source state and the residence
state may come to different conclusions regarding the appropriate
taxation principles that apply to a particular type of taxpayer or a
particular type of income. Such differences reflect how each state
has decided to assert its taxing jurisdiction over that taxpayer or
item of income and may or may not affect the source state's
willingness to forego its taxing rights in whole or in part during
the treaty negotiation process.

The approach adopted in these final regulations is consistent with
the evolving multilateral consensus among the member countries of
the Organization for Economic Cooperation and Development (OECD) on
the appropriate method for source countries to follow to determine
if they should provide treaty benefits on items of income paid to
fiscally transparent entities, particularly when an entity
classification conflict exists between the source and residence
states. This evolving multilateral consensus is described in greater
detail in the OECD report, "The Application of the OECD Model Tax
Convention to Partnerships" (OECD Partnership Report). The report
generally provides that a source state is required to grant treaty
benefits on income paid to an entity only if the income is
considered to be derived by a resident of a treaty partner for
purposes of the treaty partner's tax laws. IRS and Treasury will
continue to coordinate these issues with U.S. tax treaty partners
both bilaterally and multilaterally to resolve substantive issues
arising from application of the principles set forth in the section
894 regulations and the OECD Partnership Report.

These regulations apply with respect to all U.S. income tax treaties
regardless of whether such treaties contain partnership provisions,
unless the competent authorities agree otherwise. As with the
proposed and temporary regulations, the final regulations address
only the treatment of U.S. source income that is not effectively
connected with the conduct of a U.S. trade or business. The IRS and
Treasury may issue additional regulations addressing the
availability of other tax treaty benefits, such as the application
of business profits provisions, with respect to the income of
fiscally transparent entities, particularly where a conflict in
entity classification exists.

II. Objective Versus Subjective Regulatory Approach The temporary
and proposed section 894 regulations adopted an objective approach
to determining whether the United States should grant treaty
benefits on U.S. source items of income paid to entities.
Application of the regulations did not turn on whether there existed
a tax avoidance motive for choosing a particular transaction or
structure.

Commentators recommended a narrower approach that would deny treaty
benefits on items of income paid to an entity only if the entity
served a tax avoidance purpose. As part of this approach,
commentators requested implementation of a ruling procedure that
could be used to claim treaty benefits by rebutting any deemed tax
avoidance motive for the items of income paid to an entity. This
suggestion was not adopted. These final regulations are intended to
provide objective rules regarding eligibility for treaty benefits on
certain items of U.S. source income paid to entities. Although a
ruling procedure was not adopted, taxpayers may still invoke the
Mutual Agreement Procedures under an applicable treaty in
appropriate circumstances. III. Simplified Standard For Determining
When U.S. Source Income is Derived by a Treaty Resident

The proposed and temporary regulations provided that the tax imposed
by sections 871(a), 881(a), 1461, and 4948(a) on an item of income
received by an entity is eligible for reduction under the terms of
an income tax treaty to which the United States is a party if such
item of income is treated as derived by a resident of an applicable
treaty jurisdiction, such resident is a beneficial owner of the item
of income, and all other applicable requirements for benefits under
the treaty are satisfied. The proposed and temporary regulations
further provided that an item of income received by an entity is
treated as derived by a resident only to the extent the item of
income is subject to tax in the hands of a resident of such
jurisdiction. Numerous comments were received stating that this
general rule needed clarification. As a result, the IRS and Treasury
are eliminating the use of the terms beneficial ownership and
subject to tax from the general rule, as described in greater detail
below.

A. Beneficial ownership

Commentators requested clarification regarding the relationship
between beneficial owner and the §1.881-3 anti-conduit regulations
issued under the authority of section 7701(l). The anti-conduit
rules under section 7701(l) are incorporated into the U.S.
determination of beneficial owner. They are not separate additional
requirements. The concept of beneficial owner was included in the
proposed regulations to explain the circumstances under which a
hybrid entity may beneficially own an item of income for purposes of
an income tax treaty, in light of the then proposed withholding
regulations under §1.1441-1(c)(6)(ii)(B). However, the definition of
beneficial owner in §1.1441-1(c)(6) of the amended final regulations
(TD 8881 [2000-23 I.R.B 1158]) does not apply to claims for reduced
withholding under an income tax treaty. Accordingly, because there
is no longer a need to clarify the meaning of the term under the
section 1441 regulations in the treaty context, these final
regulations no longer provide specific rules for this determination.
The concept of beneficial owner nevertheless remains an important
condition for claiming tax treaty benefits that is determined under
U.S. tax principles, including the anti-conduit rules.

B. Subject to tax

Commentators suggested that the term subject to tax in the proposed
and temporary regulations was ambiguous and could be misinterpreted.
Commentators suggested that the term subject to tax could be
interpreted as requiring that an actual tax be paid rather than
requiring an exercise of taxing jurisdiction by the applicable
treaty jurisdiction, whether or not there is an actual tax paid.
Commentators suggested that such an interpretation would lead to
anomalous results, for example, in cases when the applicable treaty
jurisdiction provides an exemption from income for U.S. source
dividends under its tax laws.

The IRS and Treasury agree that the term subject to tax could cause
unintentional confusion and that a more direct and simpler way of
ensuring that an item of income is subject to the taxing
jurisdiction of the residence country is to determine if the item of
income is derived by a resident of a treaty jurisdiction. The
concept of derived by a resident is a more useful surrogate for the
concept of subject to the taxing jurisdiction of the residence
state, the necessary prerequisite for the grant of treaty benefits
on an item of income.

C. New general rule based on "derived by" standard

The regulations now provide three specific situations in which
income is derived by a resident of a treaty jurisdiction, and thus
considered subject to the taxing jurisdiction of the residence
jurisdiction and eligible for treaty benefits. In the first
situation, an item of income paid to an entity is considered to be
derived by the entity if the entity is not fiscally transparent with
respect to the item of income under the laws of the entity's
jurisdiction. The entity's jurisdiction is generally the place of
the entity's organization, although it may be the place of
management and control of the entity if it is a resident in a
jurisdiction by reason of such factors. In the second situation,
regardless of whether the entity is found to be fiscally transparent
with respect to the item of income under the laws of the entity's
jurisdiction, an interest holder in the entity may derive the item
of income if that interest holder can establish that, under the laws
of the jurisdiction in which the interest holder is a resident, the
entity is fiscally transparent with respect to the item of income.
Under this test, the interest holder itself must not be considered
fiscally transparent with respect to the item of income under the
laws of its jurisdiction in order to claim the treaty benefit of
that jurisdiction.

In the third situation, an item of income paid to a type of entity
specifically listed in a treaty as a resident of that treaty
jurisdiction is treated as derived by a resident of that
jurisdiction. The reason for this rule is that the two treaty
partners reached an explicit agreement on the appropriate treatment
of that entity and treaty benefits accordingly should be provided on
items of income paid to it.

In some circumstances, both the entity and the interest holders in
the entity will be treated as deriving the item of income under the
foregoing tests. In that event, both the interest holder and the
entity may be entitled to treaty benefits if all other conditions
are satisfied. See §1.1441-6(b)(2) for procedures for dual rate
claims under separate income tax treaties.

IV. Determining Fiscal Transparency

A. Generally

The concept of fiscally transparent therefore is critical to the
determination of whether an item of income is derived by an entity
or an interest holder in an entity. Paragraph (d)(4)(ii) of the
proposed and temporary regulations provided that an entity is
treated as fiscally transparent by a jurisdiction to the extent the
jurisdiction requires interest holders in the entity to take into
account separately on a current basis their respective shares of the
items of income paid to the entity and to determine the character of
such item as if such items were realized directly from the source
from which realized by the entity for purposes of the tax laws of
the jurisdiction. The proposed and temporary regulations further
provided that entities that are fiscally transparent for U.S.
federal income tax purposes include partnerships, common trust funds
described under section 584, simple trusts, grantor trusts, as well
as certain other entities (including entities that have a single
interest holder) that are treated as partnerships or as disregarded
entities for U.S. federal income tax purposes.

The IRS and Treasury received numerous comments regarding the
definition of fiscally transparent under the proposed regulations.
The comments stated that it is unclear, in situations when multiple
foreign jurisdictions are involved, which jurisdiction's laws apply
in determining whether an entity is fiscally transparent. The
comments further stated that the requirement that all items of
income be separately stated is not consistent with the U.S. tax
rules regarding partnerships, which permit partners not to state
separately certain items if the outcome is the same whether or not
the item is separately stated. Commentators also suggested that the
regulations were unclear as to whether fiscal transparency is an
item by item determination or a determination made with respect to
the entity as a whole.

In response to the comments, several simplifying and clarifying
changes were made to the regulations. When an entity is invoking the
treaty, paragraph (d)(3)(ii) of the final regulations provides a
definition for purposes of determining whether the entity will be
treated as fiscally transparent under the laws of the entity's
jurisdiction with respect to an item of income received by the
entity. When an interest holder in an entity is invoking the treaty,
paragraph (d)(3)(iii) of the final regulations provides a definition
for purposes of determining whether the entity will be fiscally
transparent under the laws of the interest holder's jurisdiction.
This clarifies which jurisdiction's laws apply in determining fiscal
transparency in cases in which multiple foreign jurisdictions are
involved.

Paragraphs (d)(3)(ii) and (iii) of the final regulations generally
retain the definition of fiscally transparent as provided by the
proposed and temporary regulations, with certain clarifications and
modifications. They provide that an entity will be fiscally
transparent only if inclusion by the interest holders in the entity
is required whether or not an item of income is distributed to such
interest holders and, generally, the character and source of the
item in the hands of the interest holder are determined as if such
item were realized directly from the source from which realized by
the entity. They also provide that fiscal transparency is determined
on an item of income by item of income basis. Accordingly, for
example, an entity can be fiscally transparent with respect to
interest income, but not with respect to dividend income. The
regulations further provide, however, that if an item of income is
not separately taken into account by its interest holders, the
entity may still be fiscally transparent with respect to that item
of income if failure to take the item of income into account
separately does not result in a treatment under the tax laws of the
applicable treaty jurisdiction different from that which would be
required if the interest holder did separately take the share of
such item into account. This is consistent with the U.S. tax
provisions with respect to partnerships.

Because the final regulations adopt an item by item determination of
fiscal transparency, the provision in the proposed regulations
stating that partnerships, common trust funds described in section
584, simple trusts, grantor trusts and certain other entities are
fiscally transparent for U.S. federal income tax purposes has been
deleted from the final regulations. The foregoing language implied
that fiscal transparency is determined with respect to the entity as
a whole. Although the final regulations remove this language, it is
anticipated that such entities ordinarily will be fiscally
transparent for federal income tax purposes with regard to all items
of income received by them.

B. Investment vehicles

Commentators also requested clarification regarding the treatment of
investment vehicles that may be allowed an exclusion or deduction
from income for amounts distributed to interest holders. The final
regulations clarify that if an entity such as an investment company
is not otherwise fiscally transparent as defined in paragraphs (d)
(3)(ii) and (iii) of the final regulations, it will not be deemed to
be fiscally transparent merely because it is allowed to exclude or
deduct from income amounts distributed to interest holders. Examples
provide further guidance with respect to foreign investment
vehicles, most of which will not be fiscally transparent under the
final regulations.

C. Treatment of tax exempt organizations

In addition to the foregoing, several commentators suggested that
the regulations undermine reciprocal treaty exemptions for pension
funds and other tax exempt organizations by, for example, denying
treaty benefits under circumstances when the fund or organization
invests in U.S. LLCs that are treated as partnerships for purposes
of U.S. tax law and as corporations under the laws of the applicable
treaty jurisdiction. Treasury does not believe that the regulations
conflict with U.S. treaty obligations to provide reduced treaty
rates to pension funds and other tax exempt organizations investing
in the United States. In most cases, the denial of benefits
described by commentators can be avoided by ensuring that the
pension fund or tax exempt organization invests directly or through
an entity treated as fiscally transparent under the laws of the
jurisdiction of the fund or organization, with the result that the
fund or organization will still be able to claim exemptions under
the applicable treaty. In addition, treaties may be negotiated that
permit pensions and other tax exempt organizations to invest in the
United States through nonfiscally transparent entities and still
obtain reduced treaty rates. (See for example paragraph 2(b) of
Article XXI of the U.S.-Canada treaty, with respect to pension
funds). Further, paragraph (d)(4) gives the competent authorities
the flexibility, in appropriate circumstances, to enter into a
mutual reciprocal understanding that would depart from the rules of
paragraph (d) with respect to certain classes of entities.

D. Treatment of complex trusts

The proposed and temporary regulations did not specifically address
the treatment of section 661 trusts that are permitted to accumulate
income from year to year. Commentators suggested that they should be
treated as fiscally transparent for U.S. tax purposes because, under
section 662, the distributable net income of such trusts retains its
character in the hands of the beneficiaries if it is distributed in
the current year and not accumulated. The definitions of fiscally
transparent as set forth in the final regulations provide that, in
order for the entity to be fiscally transparent with respect to an
item of income, the interest holder must be required to take that
item of income into account in a taxable year whether or not the
item is distributed, and generally the character and source of the
item in the hands of the interest holder are determined as if such
item were realized directly from the source from which realized by
the entity.

Thus, to the extent the beneficiaries of a trust are required under
section 662 to take an item of the trust's income into account in a
taxable year, whether or not the item is distributed, and the
character and source of the item in the hands of the beneficiaries
are determined as if such item were realized directly from the
source from which realized by the entity, the trust will be treated
as fiscally transparent for U.S. tax purposes with respect to that
item of income. If inclusion by the interest holders is not required
whether or not such item of income is distributed, or the character
and source of the item in the hands of the interest holder are
determined as if such item were realized directly from the source
from which realized by the entity, the trust will not be treated as
fiscally transparent for U.S. tax purposes. In determining whether a
trust, or any other entity, is fiscally transparent with respect to
an item of income under the laws of any other jurisdiction, the
treatment of that item of income under the laws of that jurisdiction
controls, not the treatment under U.S. laws.

E. Effect of Anti-Deferral Regimes

Commentators also argued that controlled foreign corporations should
be treated as fiscally transparent to the extent interest holders
are required to account for the controlled foreign corporation's net
passive income on a current basis. This suggestion was rejected
because the nature of an inclusion under an anti-deferral regime is
that of a deemed distribution of after-tax profits of the controlled
foreign corporation, while an inclusion because an entity is
fiscally transparent is in the nature of a share of the item of
income itself, as if the interest holder realized the income
directly. This follows from the definition of fiscal transparency
contained in paragraph (d)(3)(iii), relating to whether an entity is
fiscally transparent under the laws of the interest holder's
jurisdiction.

V. Treatment of Payments To and From Domestic Reverse Hybrid
Entities

Section 1.894-1T(d)(3) provided guidance on the appropriate
treatment of items of income paid to an entity that is treated as a
domestic corporation for U.S. tax purposes but is treated as
fiscally transparent under the laws of an interest holder's
jurisdiction (a "domestic reverse hybrid" entity). That section
provided that §1.894- 1T(d)(1) may not be applied to reduce the
amount of federal income tax on U.S. source income received by a
domestic reverse hybrid entity through application of an income tax
treaty. Commentators expressed concern that this rule did not
provide sufficient guidance and could lead to inappropriate results,
noting that an item of income paid by a domestic reverse hybrid
entity could be viewed as neither "received by" the interest holder
nor "subject to tax" because the interest holder's jurisdiction
would treat the domestic reverse hybrid entity as fiscally
transparent. Thus, the interest holder's jurisdiction would view the
interest holder as "receiving" the items of income paid to the
domestic reverse hybrid entity and as being "subject to tax" on
those items of income on an immediate basis, but may not recognize
the items of income paid by the domestic reverse hybrid entity to
the interest holder.

The IRS and Treasury are also aware of certain abusive structures
involving domestic reverse hybrid entities, which are designed to
manipulate differences in U.S. and foreign entity classification
rules to produce inappropriate reductions in U.S. tax. These
transactions give rise to some of the same concerns that led to the
promulgation of the temporary and proposed regulations and caused
Congress to enact section 894(c). Treasury and the IRS expect to
issue guidance shortly regarding payments by domestic reverse hybrid
entities to their interest holders in a separate regulation package.
Thus, these final regulations reserve on the question of eligibility
for treaty benefits with respect to payments by domestic reverse
hybrid entities.

Effective Date

The final regulations apply to items of income paid on or after June
30, 2000. Withholding agents should consider the effect of these
regulations on their withholding obligations, including the need to
obtain a new withholding certificate to confirm claims of treaty
benefits for items of income paid on or after the effective date.

Special Analyses

It has been determined that this treasury decision not a significant
regulatory action as defined in Executive Order 12866. Therefore, a
regulatory assessment is not required. It has also been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations and, because these
regulations do not impose on small entities a collection of
information requirement, the Regulatory Flexibility Act (5 U.S.C.
chapter 6) does not apply. Therefore, a Regulatory Flexibility
Analysis is not required.

Drafting Information

The principal author of these regulations is Shawn R. Pringle of the
Office of Associate Chief Counsel (International). However, other
personnel from the IRS and Treasury participated in their
development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. Adoption of
Amendments to the Regu ations Accordingly, CFR 26 part 1 is amended
as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority for part 1 is amended by revising the
entry for section 1.894-1 to read in part as follows:

Authority: 26 U.S.C. 7805. * * *

Section 1.894-1 also issued under 26 U.S.C. 894 and 7701(l). * * *

Par. 2. In §1.894-1, paragraph (d) is revised to read as follows:

§1.894-1 Income affected by treaty.

* * * * *

(d) Special rule for items of income received by entities--(1) In
general. The tax imposed by sections 871(a), 881(a), 1443, 1461, and
4948(a) on an item of income received by an entity, wherever
organized, that is fiscally transparent under the laws of the United
States and/or any other jurisdiction with respect to an item of
income shall be eligible for reduction under the terms of an income
tax treaty to which the United States is a party only if the item of
income is derived by a resident of the applicable treaty
jurisdiction. For this purpose, an item of income may be derived by
either the entity receiving the item of income or by the interest
holders in the entity or, in certain circumstances, both. An item of
income paid to an entity shall be considered to be derived by the
entity only if the entity is not fiscally transparent under the laws
of the entity's jurisdiction, as defined in paragraph (d)(3)(ii) of
this section, with respect to the item of income. An item of income
paid to an entity shall be considered to be derived by the interest
holder in the entity only if the interest holder is not fiscally
transparent in its jurisdiction with respect to the item of income
and if the entity is considered to be fiscally transparent under the
laws of the interest holder's jurisdiction with respect to the item
of income, as defined in paragraph (d)(3)(iii) of this section.
Notwithstanding the preceding two sentences, an item of income paid
directly to a type of entity specifically identified in a treaty as
a resident of a treaty jurisdiction shall be treated as derived by a
resident of that treaty jurisdiction.

(2) Application to domestic reverse hybrid entities--(i) In general.
An income tax treaty may not apply to reduce the amount of federal
income tax on U.S. source payments received by a domestic reverse
hybrid entity. Further, notwithstanding paragraph (d)(1) of this
section, the foreign interest holders of a domestic reverse hybrid
entity are not entitled to the benefits of a reduction of U.S.
income tax under an income tax treaty on items of income received
from U.S. sources by such entity. A domestic reverse hybrid entity
is a domestic entity that is treated as not fiscally transparent for
U.S. tax purposes and as fiscally transparent under the laws of the
interest holder's jurisdiction, with respect to the item of income
received by the domestic entity.

(ii) Payments by domestic reverse hybrid entities. [Reserved].

(3) Definitions--(i) Entity. For purposes of this paragraph (d), the
term entity shall mean any person that is treated by the United
States or the applicable treaty jurisdiction as other than an
individual. The term entity includes disregarded entities, including
single member disregarded entities with individual owners.

(ii) Fiscally transparent under the law of the entity's
jurisdiction--(A) General rule. For purposes of this paragraph (d),
an entity is fiscally transparent under the laws of the entity's
jurisdiction with respect to an item of income to the extent that
the laws of that jurisdiction require the interest holder in the
entity, wherever resident, to separately take into account on a
current basis the interest holder's respective share of the item of
income paid to the entity, whether or not distributed to the
interest holder, and the character and source of the item in the
hands of the interest holder are determined as if such item were
realized directly from the source from which realized by the entity.

However, the entity will be fiscally transparent with respect to the
item of income even if the item of income is not separately taken
into account by the interest holder, provided the item of income, if
separately taken into account by the interest holder, would not
result in an income tax liability for that interest holder different
from that which would result if the interest holder did not take the
item into account separately, and provided the interest holder is
required to take into account on a current basis the interest
holder's share of all such nonseparately stated items of income paid
to the entity, whether or not distributed to the interest holder. In
determining whether an entity is fiscally transparent with respect
to an item of income in the entity's jurisdiction, it is irrelevant
that, under the laws of the entity's jurisdiction, the entity is
permitted to exclude such item from gross income or that the entity
is required to include such item in gross income but is entitled to
a deduction for distributions to its interest holders.

(B) Special definitions. For purposes of this paragraph (d)(3)(ii),
an entity's jurisdiction is the jurisdiction where the entity is
organized or incorporated or may otherwise be considered a resident
under the laws of that jurisdiction. An interest holder will be
treated as taking into account that person's share of income paid to
an entity on a current basis even if such amount is taken into
account by the interest holder in a taxable year other than the
taxable year of the entity if the difference is due solely to
differing taxable years.

(iii) Fiscally transparent under the law of an interest holder's
jurisdiction--(A) General rule. For purposes of this paragraph (d),
an entity is treated as fiscally transparent under the law of an
interest holder's jurisdiction with respect to an item of income to
the extent that the laws of the interest holder's jurisdiction
require the interest holder resident in that jurisdiction to
separately take into account on a current basis the interest
holder's respective share of the item of income paid to the entity,
whether or not distributed to the interest holder, and the character
and source of the item in the hands of the interest holder are
determined as if such item were realized directly from the source
from which realized by the entity. However, an entity will be
fiscally transparent with respect to the item of income even if the
item of income is not separately taken into account by the interest
holder, provided the item of income, if separately taken into
account by the interest holder, would not result in an income tax
liability for that interest holder different from that which would
result if the interest holder did not take the item into account
separately, and provided the interest holder is required to take
into account on a current basis the interest holder's share of all
such nonseparately stated items of income paid to the entity,
whether or not distributed to the interest holder. An entity will
not be treated as fiscally transparent with respect to an item of
income under the laws of the interest holder's jurisdiction,
however, if, under the laws of the interest holder's jurisdiction,
the interest holder in the entity is required to include in gross
income a share of all or a part of the entity's income on a current
basis year under any type of anti-deferral or comparable mechanism.
In determining whether an entity is fiscally transparent with
respect to an item of income under the laws of an interest holder's
jurisdiction, it is irrelevant how the entity is treated under the
laws of the entity's jurisdiction.

(B) Special definitions. For purposes of this paragraph (d)(3)(iii),
an interest holder's jurisdiction is the jurisdiction where the
interest holder is organized or incorporated or may otherwise be
considered a resident under the laws of that jurisdiction. An
interest holder will be treated as taking into account that person's
share of income paid to an entity on a current basis even if such
amount is taken into account by such person in a taxable year other
than the taxable year of the entity if the difference is due solely
to differing taxable years.

(iv) Applicable treaty jurisdiction. The term applicable treaty
jurisdiction means the jurisdiction whose income tax treaty with the
United States is invoked for purposes of reducing the rate of tax
imposed under sections 871(a), 881(a), 1461, and 4948(a).

(v) Resident. The term resident shall have the meaning assigned to
such term in the applicable income tax treaty.

(4) Application to all income tax treaties. Unless otherwise
explicitly agreed upon in the text of an income tax treaty, the
rules contained in this paragraph (d) shall apply in respect of all
income tax treaties to which the United States is a party.
Notwithstanding the foregoing sentence, the competent authorities
may agree on a mutual basis to depart from the rules contained in
this paragraph (d) in appropriate circumstances.However, a reduced
rate under a tax treaty for an item of U.S. source income paid will
not be available irrespective of the provisions in this paragraph
(d) to the extent that the applicable treaty jurisdiction would not
grant a reduced rate under the tax treaty to a U.S. resident in
similar circumstances, as evidenced by a mutual agreement between
the relevant competent authorities or by a public notice of the
treaty jurisdiction. The Internal Revenue Service shall announce the
terms of any such mutual agreement or public notice of the treaty
jurisdiction. Any denial of tax treaty benefits as a consequence of
such a mutual agreement or notice shall affect only payment of U.S.
source items of income made after announcement of the terms of the
agreement or of the notice.

(5) Examples. This paragraph (d) is illustrated by the following
examples: Example 1. Treatment of entity treated as partnership by
U.S. and country of organization. (i) Facts. Entity A is a business
organization formed under the laws of Country X that has an income
tax treaty in effect with the United States. A is treated as a
partnership for U.S. federal income tax purposes. A is also treated
as a partnership under the laws of Country X, and therefore Country
X requires the interest holders in A to separately take into account
on a current basis their respective shares of the items of income
paid to A, whether or not distributed to the interest holders, and
the character and source of the items in the hands of the interest
holders are determined as if such items were realized directly from
the source from which realized by A. A receives royalty income from
U.S. sources that is not effectively connected with the conduct of a
trade or business in the United States.

(ii) Analysis. A is fiscally transparent in its jurisdiction within
the meaning of paragraph (d)(3)(ii) of this section with respect to
the U.S. source royalty income in Country X and, thus, A does not
derive such income for purposes of the U.S.-X income tax treaty.

Example 2. Treatment of interest holders in entity treated as
partnership by U.S. and country of organization. (i) Facts. The
facts are the same as under Example 1. A's partners are M, a
corporation organized under the laws of Country Y that has an income
tax treaty in effect with the United States, and T, a corporation
organized under the laws of Country Z that has an income tax treaty
in effect with the United States. M and T are not fiscally
transparent under the laws of their respective countries of
incorporation. Country Y requires M to separately take into account
on a current basis M's respective share of the items of income paid
to A, whether or not distributed to M, and the character and source
of the items of income in M's hands are determined as if such items
were realized directly from the source from which realized by A.
Country Z treats A as a corporation and does not require T to take
its share of A's income into account on a current basis whether or
not distributed.

(ii) Analysis. M is treated as deriving its share of the U.S. source
royalty income for purposes of the U.S.-Y income tax treaty because
A is fiscally transparent under paragraph (d)(3)(iii) with respect
to that income under the laws of Country Y. Under Country Z law,
however, because T is not required to take into account its share of
the U.S. source royalty income received by A on a current basis
whether or not distributed, A is not treated as fiscally
transparent. Accordingly, T is not treated as deriving its share of
the U.S. source royalty income for purposes of the U.S.-Z income tax
treaty.

Example 3. Dual benefits to entity and interest holder. (i) Facts.
The facts are the same as under Example 2, except that A is taxable
as a corporation under the laws of Country X. Article 12 of the
U.S.-X income tax treaty provides for a source country reduced rate
of taxation on royalties of 5-percent. Article 12 of the U.S.-Y
income tax treaty provides that royalty income may only be taxed by
the beneficial owner's country of residence.

(ii) Analysis. A is treated as deriving the U.S. source royalty
income for purposes of the U.S.-X income tax treaty because it is
not fiscally transparent with respect to the item of income within
the meaning of paragraph (d)(3)(ii) of this section in Country X,
its country of organization. M is also treated as deriving its share
of the U.S. source royalty income for purposes of the U.S.-Y income
tax treaty because A is fiscally transparent under paragraph (d)(3)
(iii) of this section with respect to that income under the laws of
Country Y. T is not treated as deriving the U.S. source royalty
income for purposes of the U.S.-Z income tax treaty because under
Country Z law A is not fiscally transparent. Assuming all other
requirements for eligibility for treaty benefits have been
satisfied, A is entitled to the 5-percent treaty reduced rate on
royalties under the U.S.-X income tax treaty with respect to the
entire royalty payment. Assuming all other requirements for treaty
benefits have been satisfied, M is also entitled to a zero rate
under the U.S.-Y income tax treaty with respect to its share of the
royalty income.

Example 4. Treatment of grantor trust. (i) Facts. Entity A is a
trust organized under the laws of Country X, which does not have an
income tax treaty in effect with the United States. M, the grantor
and owner of A for U.S. income tax purposes, is a resident of
Country Y, which has an income tax treaty in effect with the United
States. M is also treated as the grantor and owner of the trust
under the laws of Country Y. Thus, Country Y requires M to take into
account all items of A's income in the taxable year, whether or not
distributed to M, and determines the character of each item in M's
hands as if such item was realized directly from the source from
which realized by A. Country X does not treat M as the owner of A
and does not require M to account for A's income on a current basis
whether or not distributed to M. A receives interest income from
U.S. sources that is neither portfolio interest nor effectively
connected with the conduct of a trade or business in the United
States.

(ii) Analysis. A is not fiscally transparent under the laws of
Country X within the meaning of paragraph (d)(3)(ii) of this section
with respect to the U.S. source interest income, but A may not claim
treaty benefits because there is no U.S.-X income tax treaty. M,
however, does derive the income for purposes of the U.S.-Y income
tax treaty because under the laws of Country Y, A is fiscally
transparent.

Example 5. Treatment of complex trust. (i) Facts. The facts are the
same as in Example 4 except that M is treated as the owner of the
trust only under U.S. tax law, after application of section 672(f),
but not under the law of Country Y. Although the trust document
governing A does not require that A distribute any of its income on
a current basis, some distributions are made currently to M. There
is no requirement under Country Y law that M take into account A's
income on a current basis whether or not distributed to him in that
year. Under the laws of Country Y, with respect to current
distributions, the character of the item of income in the hands of
the interest holder is determined as if such item were realized
directly from the source from which realized by A. Accordingly, upon
a current distribution of interest income to M, the interest income
retains its source as U.S. source income.

(ii) Analysis. M does not derive the U.S. source interest income
because A is not fiscally transparent under paragraph (d)(3)(ii) of
this section with respect to the U.S. source interest income under
the laws of Country Y. Although the character of the interest in the
hands of M is determined as if realized directly from the source
from which realized by A, under the laws of Country Y, M is not
required to take into account his share of A's interest income on a
current basis whether or not distributed. Accordingly, neither A nor
M is entitled to claim treaty benefits, since A is a resident of a
non-treaty jurisdiction and M does not derive the U.S. source
interest income for purposes of the U.S.-Y income tax treaty.

Example 6. Treatment of interest holders required to include passive
income under anti-deferral regime. (i) Facts. The facts are the same
as under Example 2. However, Country Z does require T, who is
treated as owning 60-percent of the stock of A, to take into account
its respective share of the royalty income of A under an anti-
deferral regime applicable to certain passive income of controlled
foreign corporations. (ii) Analysis. T is still not eligible to
claim treaty benefits with respect to the royalty income. T is not
treated as deriving the U.S. source royalty income for purposes of
the U.S.-Z income tax treaty under paragraph (d)(3)(iii) of this
section because T is only required to take into account its pro rata
share of the U.S. source royalty income by reason of Country Z's
anti-deferral regime.

Example 7. Treatment of contractual arrangements operating as
collective investment vehicles. (i) Facts. A is a contractual
arrangement without legal personality for all purposes under the
laws of Country X providing for joint ownership of securities.
Country X has an income tax treaty in effect with the United States.
A is a collective investment fund which is of a type known as a
Common Fund under Country X law. Because of the absence of legal
personality of the arrangement, A is not liable to tax at the entity
level in Country X and is not a resident within the meaning of the
Residence Article of the U.S.-X income tax treaty. A is treated as a
partnership for U.S. income tax purposes and receives U.S. source
dividend income. Under the laws of Country X, however, investors in
A only take into account their respective share of A's income upon
distribution from the Common Fund. Some of A's interest holders are
residents of Country X and some of Country Y. Country Y has no
income tax treaty in effect with the United States.

(ii) Analysis. A is not fiscally transparent under paragraph (d)(3)
(ii) of this section with respect to the U.S. source dividend income
because the interest holders in A are not required to take into
account their respective shares of such income in the taxable year
whether or not distributed. Because A is an arrangement without a
legal personality that is not considered a resident of Country X
under the Residence Article of the U.S.-X income tax treaty,
however, A does not derive the income for purposes of the U.S.-X
income tax treaty. Further, because A is not fiscally transparent
under paragraph (d)(3)(iii) of this section with respect to the U.S.
source dividend income, A's interest holders that are residents of
Country X do not derive the income as residents of Country X for
purposes of the U.S.-X income tax treaty..

Example 8. Treatment
of person specifically listed as resident in applicable treaty. (i)
Facts. The facts are the same as in Example 7 except that A (the
Common Fund) is organized in Country Z and the Residence Article of
the U.S.-Z income tax treaty provides that "the term 'resident of a
Contracting State' includes, in the case of Country Z, Common
Funds...."

(ii) Analysis. A is treated, for purposes of the U.S.-Z income tax
treaty as deriving the dividend income as a resident of Country Z
under paragraph (d)(1) of this section because the item of income is
paid directly to A, A is a Common Fund under the laws of Country Z,
and Common Funds are specifically identified as residents of Country
Z in the U.S.-Z treaty. There is no need to determine whether A
meets the definition of fiscally transparent under paragraph (d)(3)
(ii) of this section.

Example 9. Treatment of investment company when entity receives
distribution deductions, and all distributions sourced by residence
of entity. (i) Facts. Entity A is a business organization formed
under the laws of Country X, which has an income tax treaty in
effect with the United States. A is treated as a partnership for
U.S. income tax purposes. Under the laws of Country X, A is an
investment company taxable at the entity level and a resident of
Country X. It is also entitled to a distribution deduction for
amounts distributed to its interest holders on a current basis. A
distributes all its net income on a current basis to its interest
holders and, thus, in fact, has no income tax liability to Country
X. A receives U.S. source dividend income. Under Country X law, all
amounts distributed to interest holders of this type of business
entity are treated as dividends from sources within Country X and
Country X imposes a withholding tax on all payments by A to foreign
persons. Under Country X laws, the interest holders in A do not have
to separately take into account their respective shares of A's
income on a current basis if such income is not, in fact,
distributed.

(ii) Analysis. A is not fiscally transparent under paragraph (d)(3)
(ii) of this section with respect to the U.S. source dividends
because the interest holders in A do not have to take into account
their respective share of the U.S. source dividends on a current
basis whether or not distributed. A is also not fiscally transparent
under paragraph (d)(3)(ii) of this section because there is a change
in source of the income received by A when A distributes the income
to its interest holders and, thus, the character and source of the
income in the hands of A's interest holder are not determined as if
such income were realized directly from the source from which
realized by A. Accordingly, A is treated as deriving the U.S. source
dividends for purposes of the U.S.-Country X treaty.

Example 10. Item by item determination of fiscal transparency. (i)
Facts. Entity A is a business organization formed under the laws of
Country X, which has an income tax treaty in effect with the United
States. A is treated as a partnership for U.S. income tax purposes.
Under the laws of Country X, A is an investment company taxable at
the entity level and a resident of Country X. It is also entitled to
a distribution deduction for amounts distributed to its interest
holders on a current basis. A receives both U.S. source dividend
income and interest income from U.S. sources that is neither
portfolio interest nor effectively connected with the conduct of a
trade or business in the United States. Country X law sources all
distributions attributable to dividend income based on the residence
of the investment company. In contrast, Country X law sources all
distributions attributable to interest income based on the residence
of the payor of the interest. No withholding applies with respect to
distributions attributable to U.S. source interest and the character
of the distributions attributable to the interest income remains the
same in the hands of A's interest holders as if such items were
realized directly from the source from which realized by A. However,
under Country X law the interest holders in A do not have to take
into account their respective share of the interest income received
by A on a current basis whether or not distributed.

(ii) Analysis. An item by item analysis is required under paragraph
(d) of this section. The analysis is the same as Example 9 with
respect to the dividend income. A is also not fiscally transparent
under paragraph (d)(3)(ii) of this section with respect to the
interest income because, although the character of the distributions
attributable to the interest income in the hands of A's interest
holders is determined as if realized directly from the source from
which realized by A, under Country X law the interest holders in A
do not have to take into account their respective share of the
interest income received by A on a current basis whether or not
distributed. Accordingly, A derives the U.S. source interest income
for purpose of the U.S.-X treaty.

Example 11. Treatment of charitable organizations. (i) Facts. Entity
A is a corporation organized under the laws of Country X that has an
income tax treaty in effect with the United States. Entity A is
established and operated exclusively for religious, charitable,
scientific, artistic, cultural, or educational purposes. Entity A
receives U.S. source dividend income from U.S. sources. A provision
of Country X law generally exempts Entity A's income from Country X
tax due to the fact that Entity A is established and operated
exclusively for religious, charitable, scientific, artistic,
cultural, or educational purposes. But for such provision, Entity
A's income would be subject to tax by Country X.

(ii) Analysis. Entity A is not fiscally transparent under paragraph
(d)(3)(ii) of this section with respect to the U.S. source dividend
income because, under Country X law, the dividend income is treated
as an item of income of A and no other persons are required to take
into account their respective share of the item of income on a
current basis, whether or not distributed. Accordingly, Entity A is
treated as deriving the U.S. source dividend income.

Example 12. Treatment of pension trusts. (i) Facts. Entity A is a
trust established and operated in Country X exclusively to provide
pension or other similar benefits to employees pursuant to a plan.
Entity A receives U.S. source dividend income. A provision of
Country X law generally exempts Entity A's income from Country X tax
due to the fact that Entity A is established and operated
exclusively to provide pension or other similar benefits to
employees pursuant to a plan. Under the laws of Country X, the
beneficiaries of the trust are not required to take into account
their respective share of A's income on a current basis, whether or
not distributed and the character and source of the income in the
hands of A's interest holders are not determined as if realized
directly from the source from which realized by A.

(ii) Analysis. A is not fiscally transparent under paragraph (d)(3)
(ii) of this section with respect to the U.S. source dividend income
because under the laws of Country X, the beneficiaries of A are not
required to take into account their respective share of A's income
on a current basis, whether or not distributed. A is also not
fiscally transparent under paragraph (d)(3)(ii) of this section with
respect to the U.S. source dividend income because under the laws of
Country X, the character and source of the income in the hands of
A's interest holders are not determined as if realized directly from
the source from which realized by A. Accordingly, A derives the U.S.
source dividend income for purposes of the U.S.-X income tax
treaty..(6) Effective date. This paragraph (d) applies to items of
income paid on or after

June 30, 2000.
Robert E Wenzel
Deputy Commissioner of Internal Revenue
Approved: 06/28/00
Jonathan Talisman
Deputy Assistant Secretary of the Treasury (Tax Policy)

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