ARTICLE 9 Permanent Establishment 　　This article defines the term "permanent establishment". The existence of a permanent establishment is, under the terms of the Convention, a prerequisite for one State to tax the industrial or commercial profits of a resident of the other State. The concept is also significant in determining the applicability of other provisions of the Convention, such as Articles 12 (relating to dividends), 13 (relating to interest), 14 (relating to royalties), and 16 (relating to capital gains). The definition of "permanent establishment" is a modernized version of the definition found in some of our older treaties, including the 1954 Convention. The new definition is similar to the definition found in most of our recent conventions. 　　The term "permanent establishment" means "a fixed place of business through which a resident of a Contracting State engages in industrial or commercial activity". Illustrations of the concept of a fixed place of business include a branch, an office, a factory, a workshop, a warehouse, a place of extraction of natural resources, or a building site or construction or installation project which exists for more than 24 months. The construction project rule is a physical presence test under which the resident must be actively engaged in the project during the specified period. The time period has been expanded from the 12-month period used in the 1954 Convention in recognition of the changing nature of construction activity whereby a construction project may continue for more than 12 months and still maintain its essentially temporary nature. The 1954 Convention provided that an enterprise of one Contracting State had a permanent establishment in the other Contracting State if it carried on supervisory activities in the other State for more than 12 months in connection with a construction, installation, or assembly project located in the other State. The conduct of such supervisory activities has not been included in the illustrations of the concept of a fixed place of business in the new Convention. The determination of whether the conduct of supervisory activities constitutes a permanent establishment will be made upon the basis of the principles ordinarily used in making such a determination. As a general rule, any fixed facility through which an individual, corporation, or other person conducts industrial or commercial activity will be treated as a permanent establishment unless it falls in one of the specific exceptions described below. 　　This article specifically provides that a permanent establishment does not include a fixed place of business of a resident of one of the Contracting States which is located in the other Contracting State if it is used only for one or more of the following: 　　(1) the storage, display, or delivery of goods or merchandise belonging to the resident; 　　(2) the maintenance of a stock of goods or merchandise belonging to the resident for the purpose of storage, display, or delivery; 　　(3) the maintenance of a stock of goods or merchandise belonging to the resident for the purpose of processing by another person; 　　(4) the purchase of goods or merchandise, or the collection of information, for the resident; or 　　(5) advertising, the supply of information, the conduct of scientific research, or similar activities which have a preparatory or auxiliary character, for the resident. 　　These exceptions are cumulative and a site or facility used solely for one or more of these purposes will not be considered a permanent establishment. The exception for cases where goods of a resident are processed by another person includes cases where the resident furnishes the other person with the tools and dies necessary for the processing. Although no specific exception is made in the case of a building site or construction or installation project which exists for not more than 24 months, the Convention implies that such a site or project does not constitute a permanent establishment. 　　Notwithstanding the other provisions of this article, a person will be considered to have a permanent establishment if he engages in business through an agent, other than an independent agent, who has and regularly exercises authority to conclude contracts in the name of such person unless the agent only exercises such authority to purchase goods or merchandise. 　　The Convention also provides that a resident of one State will not be deemed to have a permanent establishment in the other State if such resident engages in industrial or commercial activity in such other State through an independent agent, such as a broker or general commission agent, if such agent is acting in the ordinary course of its business. 　　The determination of whether a resident of one State has a permanent establishment in the other State is to be made without regard to any control relationship between such resident and a resident of the other State or a person which engages in industrial or commercial activity in that other State (whether through a permanent establishment or otherwise). 　　Where it is necessary under the Convention to determine whether a permanent establishment exists in a third State, the standards of this article are to be applied. Such a determination may be necessary under paragraph (2) of Article 6 relating to the source of interest income. ARTICLE 10 Shipping and Air Transport 　　This article provides that, notwithstanding Article 8 (relating to business profits) and Article 16 (relating to capital gains), income which a resident of the United States derives from operation in international traffic of ships or aircraft registered in the United States, and gains which a resident of the United States derives from the sale; exchange, or other disposition of ships or aircraft operated in international traffic by such resident and registered in the United States, are exempt from tax in Japan. 　　This article provides a similar exemption from United States tax for such income and gains derived by a resident of Japan. However, with regard to income of residents of Japan, the ships or aircraft need not be registered in Japan if they are leased by such a resident. 　　This article does not contain any provision exempting shipping or air profits from local taxes. However, it was agreed in an exchange of notes accompanying the Convention that the enterprise tax levied in Japan on behalf of local governments would not be imposed on United States airlines and shipping companies if state, county, or local governments in the United States do not levy upon Japanese airlines and shipping companies any tax of a character substantially similar to the enterprise tax in Japan. The enterprise tax is a tax imposed by Japan for the prefectures upon net profits from business. It is imposed upon both individuals and corporations, although the rates and method of calculating net profits are somewhat different. At the present time, no such state or local tax is imposed on Japanese airlines and shipping companies in the United States. 　　In addition, notes were exchanged covering the use of containers in international traffic and the lease of ships or aircraft used in international traffic. It was agreed that income derived by a resident engaged in the operation in international traffic of ships or aircraft from the use, maintenance, or lease of containers and related equipment in connection with such operations is exempt as falling within the scope of this article. It was also agreed that income derived by a resident engaged in the operation in international traffic of ships or aircraft from a full or bareboat charter to another person engaged in the operation in international traffic of ships or aircraft also falls within the scope of this article. 　　Consistent with the above principles, other income from the leasing of ships or aircraft received by a person engaged in the operation in international traffic of ships or aircraft (i.e., a lease to a person not engaged in international traffic) may also be within the scope of this article if such leasing activity is subsidiary and ancillary to the lessor's international operations. ARTICLE 11 Related Persons 　　This article complements section 482 of the Internal Revenue Code and confirms the power of each government under its internal laws to allocate items of income, deduction, credit, or allowance in cases in which a resident of one State is related to any other person if such related persons impose conditions between themselves which are different from conditions which would be imposed between independent persons. A similar provision was included in the 1954 Convention and in the OECD Model Convention. 　　Provision is made in Article 25 (relating to mutual agreement procedures) for consultation and agreement between the two States where an allocation by either State results or would result in double taxation. ARTICLE 12 Dividends 　　The 1954 Convention provided that dividends derived from sources within one State by a resident of the other State not having a permanent establishment in the former State (other than certain permanent establishments of the construction type) would be subject to tax in the former State at a rate not in excess of 15 percent. However, it provided for a 10 percent rate with respect to intercorporate dividends if, for the 12 months immediately preceding the date of payment, the recipient owned more than 50 percent of the stock of the paying corporation either alone or in association with not more than three other corporations of such other State, provided that each such corporation of the other State - owned 10 percent or more of the stock of the payor corporation and, generally, if not more than 25 percent of the gross income of the paying corporation for such period consisted of dividends and interest. 　　The new Convention continues the 15 percent rate with respect to dividends on portfolio investments and the 10 percent rate on intercorporate dividends. However, under the new Convention the maximum rate of 10 percent with respect to intercorporate dividends applies if, during the part of the paying corporation's taxable year which precedes the date of payment of the dividend and during the whole of its prior taxable year, the recipient owns 10 percent or more of the voting shares of the paying corporation and, generally, if not more than 25 percent of the gross income of the paying corporation for such prior taxable year consists of dividends and interest. 　　The dividend article is patterned generally after the OECD Model Convention except, with respect to the qualification for the 10 percent intercorporate dividend rate, a 10 percent ownership requirement is substituted or the 25 percent ownership requirement of the OECD draft. The 10 percent rule conforms to the United States concept of direct investment especially as expressed in section 902 of the Internal Revenue Code. In addition, the Convention limits to 25 percent the amount of passive income which may be derived by a corporation paying dividends in order to qualify for the reduced intercorporate dividend rate. This provision, which is included in most conventions to which the United States is a party but which is not found in the OECD draft, reflects the policy that the reduced rate should not be made available to dividends paid by certain holding companies. Dividends and interest received by the payor corporation from 50 percent or more owned subsidiaries are not considered passive income. 　　The use of the term "actually distributed" is intended to make clear that the rate of withholding applies to the amount paid by the distributing corporation and not to the amount received (which would be a lesser amount due to withholding). The term is not intended to mean that there must be an actual physical transfer of funds for the reduced rates to apply, as in the case of the obligation to pay a dividend being satisfied by the offset of an account payable by the stockholder to the distributing corporation. 　　The Convention abandons the "force of attraction" concept in the 1954 Convention by providing that the reduced rates of tax on dividends are denied only if the share with respect to which the dividends are paid are effectively connected with a permanent establishment which the recipient has in the State of source. The elimination of the "force of attraction" principle will make uniform the rate of tax levied on dividend income received by a resident of one State from sources within the other State unless such income is effectively connected with a permanent establishment maintained in the State of source by the resident. In those cases where the shares with respect to which the dividends are paid are so effectively connected, the dividends may be taxed as industrial or commercial profits under Article 8 (relating to business profits) at normal rates applicable to such income in the State of source. 　　The Convention does not contain the provision found in many of our recent conventions limiting the right of a State to tax dividends paid by a corporation of the other State to residents of third States. This could not occur under present Japanese tax law since a dividend paid by a United States corporation would be considered United States sourced and would, therefore, not be subject to Japanese tax when received by a nonresident of Japan. However, under sections 861(a)(2)(B) and 1442 of the Internal Revenue Code, dividends paid by a Japanese corporation to a resident of a third State could be treated in whole or in part as United States source income if such a case were to arise. This could happen only where over 50 percent of the Japanese corporation's income is effectively connected with a U.S. trade or business over a specified 3- year period of time. ARTICLE 13 Interest 　　The 1954 Convention provided that interest derived from sources within one State by a resident of the other State not having a permanent establishment in the former State would be subject to tax in the former State at a rate not in excess of 10 percent. 　　The new Convention retains the 10-percent rate on interest. The Convention also provides that interest derived from sources within the United States will be exempt from United States tax if such interest is derived by the Bank of Japan or by the Export- Import Bank of Japan, or by any resident of Japan either with respect to debt obligations guaranteed or indirectly financed by either of such Japanese banks or with respect to debt obligations insured by Japan pursuant to Law No.67, March 31, 1950, concerning Export Insurance. In an exchange of notes the Contracting States stated an understanding that a debt obligation would be treated as indirectly financed by the Export-Import Bank of Japan in cases where that Bank provides funds in the form of export credit, import credit, or investment credit to a resident of Japan for the purpose of permitting the resident of Japan to extend credit to a resident of the United States and the debt obligation represents such extension of credit to the resident of the United States. 　　A reciprocal exemption is also provided in the case of interest derived from sources within Japan by any Federal Reserve Bank in the United States or by the Export-Import Bank of the United States, or by any resident of the United States with respect to debt obligations guaranteed, insured, or indirectly financed by any of such United States banks. The 1954 Convention provided similar reciprocal exemptions, but the exemptions were limited to interest derived by the central banks and the Export-Import Banks of the Contracting States. 　　As noted above in connection with Article 12 (relating to dividends), the Convention abandons the "force of attraction" principle, replacing it with the effectively connected approach. Thus, the reduced rates of tax and the exemptions applicable to interest apply unless the recipient has a permanent establishment in the State of source and the indebtedness giving rise to the interest is effectively connected with such permanent establishment. In such a case, the interest may be taxed as industrial or commercial profits. 　　Interest is defined generally as income from any kind of debt-claim or any income treated as interest under the tax law of the State of source. If excessive interest is paid by a payor who is related to the recipient, the provisions of this article apply only to so much of the interest as would have been paid to an unrelated person. Excess interest payments may be taxed by each State according to its own law including the provisions of the Convention where applicable. 　　The source of interest income is determined under paragraph (2) of Article 6 (relating to the source of income) 　　As in the case of dividends, the Convention does not contain the provision found in many of our recent conventions exempting from tax by one of the States interest paid by a resident of the other State to a resident of a third State. Under Japanese tax law, interest paid by a United States resident to a resident of a third State would not be subject to Japanese tax, but under sections 861(a)(1)(C) and (D) and 1442 of the Internal Revenue Code, interest paid by a Japanese corporation to a resident of a third State could be subject to United States tax in exceptional circumstances. This could happen only where 50 percent or more of the Japanese corporation's gross income is effectively connected with the conduct of a U.S. trade or business over a specified 3-year period. ARTICLE 14 Royalties 　　The 1954 Convention provided that royalties derived from sources within one State by a resident of the other State not having a permanent establishment in the former State (or having a permanent establishment of the construction type if the royalties are not attributable thereto) would not be subject to tax in the former State at a rate in excess of 10 percent. 　　The new Convention retains the 10-percent rate on royalties. However, as noted above in connection with Article 12 (relating to dividends) and Article 13 (relating to interest), the Convention abandons the "force of attraction" principle, replacing it with the effectively connected approach. Thus, the reduced rate of tax applies unless the recipient has a permanent establishment in the State of source and the property or rights giving rise to royalties are effectively connected with such permanent establishment. In such a case, the royalties may be taxed as industrial or commercial profits. 　　The term "royalties" is defined to include 　　(a) payments of any kind made as consideration for the use of, or the right to use, copyrights of literary, artistic, scientific works, or motion picture films or films or tapes used for radio or television broadcasting, patents; designs, or models, plans, secret processes or formulae, trademarks, or other like property or rights, or know-how, or ships or aircraft (but only if the lessor is a person not engaged in the operation in international traffic of ships or aircraft) and 　　(b) gains derived from the sale, exchange, or other disposition of such property or rights (other than ships or aircraft) to the extent that payment is contingent on productivity, use or disposition of the property or rights. 　　If the payments in the second category are not so contingent, Article 16 (relating to capital gains) applies. The term "know-how" includes existing scientific, technical, industrial and commercial knowledge or information where such knowledge or information is transmitted or supplied to the payor (as opposed to a contract for the development of knowledge or information or for the use of knowledge or information by the payee in connection with the rendition of services to the payor). The term also includes assistance of an ancillary and subsidiary nature furnished as a means of enabling the application or enjoyment of a transferred intangible. 　　If excessive royalties are paid between a payor and a related recipient, the provisions of this article apply only to so much of the royalty as would have been paid to an unrelated person. The excess payment may be taxed by each State according to its own law including the provisions of the Convention where applicable. 　　The source of income from royalties is determined under paragraph (3) of Article 6 (relating to the source of income). ARTICLE 15 Income from Real Property 　　This article provides that a resident of one State may be subject to tax in the other State on income from real property and royalties in respect of natural resources if the property or natural resource is located in such other State. The 1954 Convention provided that a resident of one State may be subject to tax on such income or royalties by the other State only if such resident had a permanent establishment in the other State or if such income or royalties constituted industrial or commercial profits. This article does not (as did the 1954 Convention) provide for an election by the resident to compute his tax on such income on a net basis since under the internal laws of Japan and, since 1967, the United States, this can be done. See sections 871(d) and 882(d) of the Internal Revenue Code. The income referred to in this article includes gain from the sale or exchange of real property or natural resource rights, but does not include interest on mortgages and similar instruments. The latter type of income is covered by Article 13 (relating to interest).