DEPARTMENT OF THE TREASURY TECHNICAL EXPLANATION OF THE CONVENTION BETWEEN THE UNITED STATES OF AMERICA AND THE REPUBLIC OF SOUTH AFRICA FOR THE AVOIDANCE OF DOUBLE TAXATION AND THE PREVENTION OF FISCAL EVASION WITH RESPECT TO TAXES ON INCOME AND CAPITAL GAINS (11) Trade or Business -- Subparagraphs 3(a)(i) and (b) 　　The term "trade or business" is not defined in the Convention. Pursuant to paragraph 2 of Article 3 (General Definitions), when determining whether a resident of South Africa is entitled to the benefits of the Convention under paragraph 3 with respect to income derived from U.S. sources, the United States will ascribe to this term the meaning that it has under the law of the United States. Accordingly, the United States competent authority will refer to the regulations issued under section 367(a) for the definition of the term "trade or business." In general, therefore, a trade or business will be considered to be a specific unified group of activities that constitute or could constitute an independent economic enterprise carried on for profit. Furthermore, a corporation generally will be considered to carry on a trade or business only if the officers and employees of the corporation conduct substantial managerial and operational activities. See Code section 367(a)(3) and the regulations thereunder. 　　Notwithstanding this general definition of trade or business, subparagraph 3(b) provides that the business of making or managing investments will be considered to be a trade or business only when part of banking, insurance or securities activities conducted by a bank, insurance company, or registered securities dealer. Conversely, such activities conducted by a person other than a bank, insurance company or registered securities dealer will not be considered to be the conduct of an active trade or business, nor would they be considered to be the conduct of an active trade or business if conducted by a bank, insurance company or securities dealer, but not as part of the company's banking, insurance or securities business. 　　Because a headquarters operation is in the business of managing investments, a company that functions solely as a headquarters company will not be considered to be engaged in an active trade or business for purposes of paragraph 3. 　　Derived in Connection With Requirement - Subparagraphs 3(a)(ii) and (d) 　　Subparagraph 3(d) provides that income is derived in connection with a trade or business if the income-producing activity in the other State is a line of business that forms a part of or is complementary to the trade or business conducted in the State of residence by the income recipient. Although no definition of the terms "forms a part of" or "complementary" is set forth in the Convention, it is intended that a business activity generally will be considered to "form a part of" a business activity conducted in the other State if the two activities involve the design, manufacture or sale of the same products or type of products, or the provision of similar services.In order for two activities to be considered to be "complementary," the activities need not relate to the same types of products or services, but they should be part of the same overall industry and be related in the sense that the success or failure of one activity will tend to result in success or failure for the other. In cases in which more than one trade or business is conducted in the other State and only one of the trades or businesses forms a part of or is complementary to a trade or business conducted in the State of residence, it is necessary to identify the trade or business to which an item of income is attributable. Royalties generally will be considered to be derived in connection with the trade or business to which the underlying intangible property is attributable. Dividends will be deemed to be derived first out of earnings and profits of the treaty-benefited trade or business, and then out of other earnings and profits. Interest income may be allocated under any reasonable method consistently applied. A method that conforms to U.S. principles for expense allocation will be considered a reasonable method. The following examples illustrate the application of subparagraph 3(d). 　　Example 1 USCo is a corporation resident in the United States. USCo is engaged in an active manufacturing business in the United States. USCo owns 100 percent of the shares of SACo, a corporation resident in South Africa. SACo distributes USCo products in South Africa. Since the business activities conducted by the two corporations involve the same products, SACo's distribution business is considered to form a part of USCo's manufacturing business within the meaning of subparagraph 3(d). 　　Example 2 The facts are the same as in Example 1, except that USCo does not manufacture. Rather, USCo operates a large research and development facility in the United States that licenses intellectual property to affiliates worldwide, including SACo. SACo and other USCo affiliates then manufacture and market the USCo-designed products in their respective markets. Since the activities conducted by SACo and USCo involve the same product lines, these activities are considered to form a part of the same trade or business. 　　Example 3 Americair is a corporation resident in the United States that operates an international airline. SASub is a wholly-owned subsidiary of Americair resident in South Africa. SASub operates a chain of hotels in South Africa that are located near airports served by Americair flights. Americair frequently sells tour packages that include air travel to South Africa and lodging at SASub hotels. Although both companies are engaged in the active conduct of a trade or business, the businesses of operating a chain of hotels and operating an airline are distinct trades or businesses. Therefore SASub's business does not form a part of Americair's business. However, SASub's business is considered to be complementary to Americair's business because they are part of the same overall industry (travel) and the links between their operations tend to make them interdependent. 　　Example 4 The facts are the same as in Example 3, except that SASub owns an office building in South Africa instead of a hotel chain. No part of Americair's business is conducted through the office building. SASub's business is not considered to form a part of or to be complementary to Americair's business. They are engaged in distinct trades or businesses in separate industries, and there is no economic dependence between the two operations. 　　Example 5 USFlower is a corporation resident in the United States. USFlower produces and sells flowers in the United States and other countries. USFlower owns all the shares of SAHolding, a corporation resident in South Africa. SAHolding is a holding company that is not engaged in a trade or business. SAHolding owns all the shares of three corporations that are resident in South Africa: SAFlower, SALawn, and SAFish. SAFlower distributes USFlower flowers under the USFlower trademark in the other State. SALawn markets a line of lawn care products in the other State under the USFlower trademark. In addition to being sold under the same trademark, SALawn and SAFlower products are sold in the same stores and sales of each company's products tend to generate increased sales of the other's products. SAFish imports fish from the United States and distributes it to fish wholesalers in South Africa. For purposes of paragraph 3, the business of SAFlower forms a part of the business of USFlower, the business of SALawn is complementary to the business of USFlower, and the business of SAFish is neither part of nor complementary to that of USFlower. 　　Finally, a resident in one of the States also will be entitled to the benefits of the Convention with respect to income derived from the other State if the income is "incidental" to the trade or business conducted in the recipient's State of residence. Subparagraph 3(d) provides that income derived from a State will be incidental to a trade or business conducted in the other State if the production of such income facilitates the conduct of the trade or business in the other State. An example of incidental income is the temporary investment of working capital derived from a trade or business. Substantiality -- Subparagraphs 3(a)(iii) and (c) 　　As indicated above, subparagraph 3(a)(iii) provides that income that a resident of a State derives from the other State will be entitled to the benefits of the Convention under paragraph 3 only if the income is derived in connection with a trade or business conducted in the recipient's State of residence and that trade or business is ?substantial? in relation to the income-producing activity in the other State. Subparagraph 3(c) provides that whether the trade or business of the income recipient is substantial will be determined based on all the facts and circumstances. These circumstances generally would include the relative scale of the activities conducted in the two States and the relative contributions made to the conduct of the trade or businesses in the two States. 　　In addition to this subjective rule, subparagraph 3(c) provides a safe harbor under which the trade or business of the income recipient may be deemed to be substantial based on three ratios that compare the size of the recipient's activities to those conducted in the other State. The three ratios compare: (i) the value of the assets in the recipient's State to the assets used in the other State; (ii) the gross income derived in the recipient's State to the gross income derived in the other State; and (iii) the payroll expense in the recipient's State to the payroll expense in the other State. 　　The average of the three ratios with respect to the preceding taxable year must exceed 10 percent, and each individual ratio must exceed 7.5 percent. If any individual ratio does not exceed 7.5 percent for the preceding taxable year, the average for the three preceding taxable years may be used instead. Thus, if the taxable year is 1998, the preceding year is 1997. If one of the ratios for 1997 is not greater than 7.5 percent, the average ratio for 1995, 1996, and 1997 with respect to that item may be used. The term "value" also is not defined in the Convention. Therefore, this term also will be defined under U.S. law for purposes of determining whether a person deriving income from United States sources is entitled to the benefits of the Convention. In such cases, "value" generally will be defined using the method used by the taxpayer in keeping its books for purposes of financial reporting in its country of residence. See Treas. Reg. ?1.884-5(e)(3)(ii)(A). 　　Only items actually located or incurred in the two Contracting States are included in the computation of the ratios. If the person from whom the income in the other State is derived is not wholly-owned by the recipient (and parties related thereto) then the items included in the computation with respect to such person must be reduced by a percentage equal to the percentage control held by persons not related to the recipient. For instance, if a United States corporation derives income from a South African corporation in which it holds 80 percent of the shares, and unrelated parties hold the remaining shares, for purposes of subparagraph 3(c) only 80 percent of the assets, payroll and gross income of the South African company would be taken into account. 　　Consequently, if neither the recipient nor a person related to the recipient has an ownership interest in the person from whom the income is derived, the substantiality test always will be satisfied (the denominator in the computation of each ratio will be zero and the numerator will be a positive number). Of course, the other two prongs of the test under paragraph 3 would have to be satisfied in order for the recipient of the item of income to receive treaty benefits with respect to that income. For example, assume that a South African resident is in the business of banking in South Africa. The bank loans money to unrelated residents of the United States. The bank would satisfy the substantiality requirement of this subparagraph with respect to interest paid on the loans because it has no ownership interest in the payors. Paragraph 4 Paragraph 4 provides that a resident of one of the States that is not otherwise entitled to the benefits of the Convention may be granted benefits under the Convention if the competent authority of the State from which benefits are claimed so determines. This discretionary provision is included in recognition of the fact that, with the increasing scope and diversity of international economic relations, there may be cases where significant participation by third country residents in an enterprise of a Contracting State is warranted by sound business practice or long-standing business structures and does not necessarily indicate a motive of attempting to derive unintended Convention benefits. The competent authority of a State will base a determination under this paragraph on whether the establishment, acquisition, or maintenance of the person seeking benefits under the Convention, or the conduct of such person's operations, has or had as one of its principal purposes the obtaining of benefits under the Convention. Thus, persons that establish operations in one of the States with the principal purpose of obtaining the benefits of the Convention ordinarily will not be granted relief under paragraph 4. The competent authority may determine to grant all benefits of the Convention, or it may determine to grant only certain benefits. For instance, it may determine to grant benefits only with respect to a particular item of income in a manner similar to paragraph 3. Further, the competent authority may set time limits on the duration of any relief granted. It is assumed that, for purposes of implementing paragraph 4, a taxpayer will not be required to wait until the tax authorities of one of the States have determined that benefits are denied before he will be permitted to seek a determination under this paragraph. In these circumstances, it is also expected that if the competent authority determines that benefits are to be allowed, they will be allowed retroactively to the time of entry into force of the relevant treaty provision or the establishment of the structure in question, whichever is later. Finally, there may be cases in which a resident of a Contracting State may apply for discretionary relief to the competent authority of his State of residence. For instance, a resident of a State could apply to the competent authority of his State of residence in a case in which he had been denied a treaty-based credit under Article 23 on the grounds that he was not entitled to benefits of the Article under Article 22. Paragraph 5 Paragraph 5 provides that the term "recognized stock exchange" means (i) the NASDAQ System owned by the National Association of Securities Dealers, and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purposes of the Securities Exchange Act of 1934; (ii) the Johannesburg Stock Exchange; and (iii) any other exchanges that the competent authorities may agree should be recognized for this purpose. Paragraph 6 　　Paragraph 6 addresses the so-called "triangular case," in which a South African enterprise derives income from the United States, and that income is attributable to a permanent establishment located in a third jurisdiction, and that third jurisdiction imposes little or no income tax liability on those profits. This provision is included in this Convention to prevent triangular case abuse in those instances in which South Africa exempts from tax profits attributable to a permanent establishment of its residents located in third countries, but would tax the income, subject to a foreign tax credit, if the income were earned directly by the South African resident and were not attributable to the permanent establishment in the third jurisdiction. Unlike most U.S. treaties in which such a provision is found, this paragraph will be applied only in limited circumstances under this Convention, unless South African law changes. Since South Africa currently does not normally tax the foreign-source income of South African residents, most items of U.S. income earned by a resident of South Africa will not be taxed whether it is earned directly by the resident or attributable to a permanent establishment in a third jurisdiction. South Africa currently does, however, treat as South African source certain items of income derived from the United States, that the United States treats as U.S. source, and subjects to source taxation in the United States. Such income would, therefore, be subject to South African tax when earned directly by a South African resident. If, however, that income is attributable to a permanent establishment in a third jurisdiction, South Africa will not tax it. It would be inappropriate to grant treaty benefits with respect to such income. 　　Paragraph 6 generally denies treaty benefits with respect to income beneficially owned by a South African resident and attributable to a permanent establishment in a third jurisdiction if the combined tax in South Africa and the third jurisdiction is less than 50 percent of the tax that would be imposed in South Africa if the income were earned by the South African resident and were not attributable to the permanent establishment. The paragraph is drafted unilaterally to apply only to income of a South African resident, since it has no application with respect to the United States because the United States does not exempt the profits of a U.S. person attributable to its foreign permanent establishments. 　　For example, assume that a South African company has a permanent establishment in a third country that imposes little tax. Assume further that the permanent establishment derives from the United States royalty income attributable to its third country permanent establishment. The royalty is paid for the exploitation of a patent that was developed in South Africa. Under South African law the source of a royalty is the place where the technology was developed. South Africa, however, will not impose its income tax on the profits of the South African company from its permanent establishment in the third country. The United States, under these circumstances, would tax the royalty at source at a rate of 15 percent. 　　The paragraph provides three exceptions to the general restrictions. First, the provisions of paragraph 6 do not apply to interest derived in connection with or incidental to an active trade or business carried on by the permanent establishment in the third jurisdiction. The business of making or managing investments is not an active trade or business for this purpose unless the activities are banking or insurance activities carried on by a bank or insurance company. Second, they do not apply to royalties received as compensation for the use of, or the right to use, intangible property produced or developed by the permanent establishment itself. Third, in the case of a South African resident with a permanent establishment in a third jurisdiction, the provisions of paragraph 6 do not apply if the profits of the permanent establishment are taxed in the United States, i.e., under the subpart F provisions of Part III of Subchapter N of chapter 1 of subtitle A of the Internal Revenue Code. 　　　　　　　　　　　　　ARTICLE 23 　　　　　　　　　Elimination of Double Taxation 　　This Article describes the manner in which each Contracting State undertakes to relieve double taxation. The United States uses the foreign tax credit method under its internal law, and by treaty. South Africa exempts many classes of foreign source income under its law. Where, however, it does tax, it also uses the foreign tax credit method to relieve double taxation. Paragraph 1 　　The United States agrees, in paragraph 1, to allow to its citizens and residents a credit against U.S. tax for income taxes paid or accrued to South Africa. By referring to "South African tax", which is defined in Article 2 (Taxes Covered) to mean the covered South African taxes, paragraph 1 also provides that South Africa's covered taxes are income taxes for purposes of the U.S. foreign tax credit. This result is based on the Treasury Department's review of South Africa's laws. 　　The credit under the Convention is allowed in accordance with the provisions and subject to the limitations of U.S. law, as that law may be amended over time, so long as the general principle of this Article, i.e., the allowance of a credit, is retained. Thus, although the Convention provides for a foreign tax credit, the terms of the credit are determined by the provisions, at the time a credit is given, of the U.S. statutory credit. 　　Subparagraph (b) provides for a deemed-paid credit, consistent with section 902 of the Code, to a U.S. corporation in respect of dividends received from a corporation resident in South Africa of which the U.S. corporation owns at least 10 percent of the voting stock. This credit is for the tax paid by the South African corporation on the profits out of which the dividends are　considered paid. For purposes of the Secondary Tax on Companies (?STC?), a corporate taxpayer may ?write up? its assets prior to making a distribution, increasing its ?distributable profits?. Such a write-up raises concerns under the realization requirement of section 1.901-2(b)(2) of the regulations. Such a write-up, however, would not be normal accounting or business practice. Therefore, this feature of the tax is unlikely to alter its predominant character as that of an income tax in the U.S. sense. Because the write-up would constitute a voluntary increase in the base on which the STC is imposed, however, the increased amount of tax on any such write-up that did occur would be non-compulsory under section 1.901-2(e)(5) and, therefore, would not be a creditable amount. 　　As indicated, the U.S. credit under the Convention is subject to the various limitations of U.S. law (see Code sections 901 - 908). For example, the credit against U.S. tax generally is limited to the amount of U.S. tax due with respect to net foreign source income within the relevant foreign tax credit limitation category (see Code section 904(a) and (d)), and the dollar amount of the credit is determined in accordance with U.S. currency translation rules (see, e.g.,Code section 986). Similarly, U.S. law applies to determine carryover periods for excess credits and other inter-year adjustments. When the alternative minimum tax is due, the alternative minimum tax foreign tax credit generally is limited in accordance with U.S. law to 90 percent of alternative minimum tax liability. Furthermore, nothing in the Convention prevents the limitation of the U.S. credit from being applied on a per-country basis (should internal law be changed), an overall basis, or to particular categories of income (see, e.g., Code section 865(h)).