source capital gains and fixed or determinable income are only ECI if they are at-
tributable to a U.S. trade or business. Fixed or determinable annual periodic income
refers to interests, dividends, rents, wages, and similar types of income. For nonfi-
nancial institutions, the primary determination of whether such income is ECI is
based upon the “asset use” test. Under this test, if the asset is held by the U.S. trade
or business, or has some type of direct relationship to the U.S. trade or business, then
the income generated by that asset is ECI. The “business activities” test is used by fi-
nancial institutions. If the business activities that generated the income are performed
by personnel associated with a U.S. office, then the income is ECI.
(c) Branch Profits Tax. As indicated at the beginning of this chapter, the United
States has the classical system of taxation, that is, income taxed both at the corporate
level and the shareholder level. Thus, income earned by a U.S. corporation is subject
to U.S. tax, and, when the income is paid out as a dividend, it is subject to a second
tax at the shareholder level. Once such income is paid out as a dividend to a foreign
shareholder, the dividend will constitute U.S. source fixed or determinable annual or
periodical income and will thus be subject to a 30% or lower treaty rate of tax.
A branch profits tax is designed to subject a U.S. branch of a foreign corporation
to the same level of tax that would be paid if the business activities were performed
in subsidiary form rather than as a branch of a foreign corporation. This is done by
imposing a 30% or lower treaty rate of tax on a foreign corporation’s “dividend
equivalent amount.” This amount is the foreign corporation’s effectively connected
earnings and profits that are not reinvested in the United States but are instead repa-
triated to the foreign head office. This means that if a foreign corporation had 100 of
effectively connected income before corporate tax, it would pay a corporate tax of 35
and then 19.5 [30% of (100 – 35)] for a total tax burden of 54.5. Just as many income
tax treaties reduce the rate of tax on dividend, many treaties either reduce the branch
profits tax or prevent the United States from imposing the branch profits tax. These
treaties are overridden by internal law if the foreign corporation is not a “qualified
resident” of the treaty country. A foreign corporation is not a “qualified resident” if it
is not owned by residents of that country or residents of the United States. Thus, for
example, if residents of a nontreaty country owned all the stock of a Dutch corpora-
tion, which in turn had a branch in the United States, the Dutch corporation would
not be considered a “qualified resident,” and thus the United States could impose the
branch profits tax. In addition to the tax on the dividend equivalent amount, there is
a branch level interest tax that operates in such a fashion as to treat interest paid by
a U.S. branch of a foreign corporation as if it were paid by a U.S. subsidiary of the
foreign corporation. Consequently, such interest paid to foreign investors would be
subject to the 30% U.S. tax unless reduced or eliminated by an income tax treaty.
30.8 INCOME TAX TREATIES
(a) United States and Income Tax Treaties. The United States has entered into many
income tax treaties. The express purpose of these treaties is to eliminate international
double taxation and render mutual assistance in tax enforcement.
(b) General Effects. The U.S. foreign tax credit goes a long way towards eliminat-
ing international double taxation of U.S. taxpayers. Many countries avoid interna-
tional double taxation by not taxing their taxpayers on foreign source income. To a
30 • 20 INTERNATIONAL TAXATION