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 (12) Paragraph 2 　　Paragraph 2 provides special rules for the tax treatment in both States of certain types of income derived from U.S. sources by U.S. citizens who are resident in South Africa. Since U.S. citizens, regardless of residence, are subject to United States tax at ordinary progressive rates on their worldwide income, the U.S. tax on the U.S. source income of a U.S. citizen resident in South Africa may exceed the U.S. tax that may be imposed under the Convention on an item of U.S. source income derived by a resident of South Africa who is not a U.S. citizen. 　　Subparagraph (a) of paragraph 2 provides special credit rules for South Africa with respect to items of income that are either exempt from U.S. tax or subject to reduced rates of U.S. tax under the provisions of the Convention when received by residents of South Africa who are not U.S. citizens. The tax credit of South Africa allowed by paragraph 2(a) under these circumstances need not exceed the U.S. tax that may be imposed under the provisions of the Convention, other than tax imposed solely by reason of the U.S. citizenship of the taxpayer under the provisions of the saving clause of paragraph 4 of Article 1 (General Scope). Thus, if a U.S. citizen resident in South Africa received U.S. source portfolio dividends, and South Africa taxed the dividend, the foreign tax credit granted by South Africa would be limited to 15 percent of the dividend -- the U.S. tax that may be imposed under subparagraph 2(b) of Article 10 (Dividends) -- even if the shareholder were subject to U.S. net income tax because of his U.S. citizenship. With respect to royalty or interest income, South Africa would not be required to allow a foreign tax credit even if it taxed the income, because its residents are exempt from U.S. tax on these classes of income under the provisions of Articles 11 (Interest) and 12 (Royalties). 　　Paragraph 2(b) eliminates the potential for double taxation that can arise because subparagraph 2(a) provides that South Africa need not provide full relief for the U.S. tax imposed on its citizens resident in South Africa. The subparagraph provides that the United States will credit the income tax paid or accrued to South Africa after the application of subparagraph 2(a). It further provides that in allowing the credit, the United States will not reduce its tax below the amount that is taken into account in South Africa in applying subparagraph 2(a). Since the income described in paragraph 2 is U.S. source income, special rules are required to resource some of the income to South Africa in order for the United States to be able to credit South Africa's tax. This resourcing is provided for in subparagraph 2(c), which deems the items of income referred to in subparagraph 2(a) to be from foreign sources to the extent necessary to avoid double taxation under paragraph 2(b). The rules of paragraph 2(c) apply only for purposes of determining U.S. foreign tax credits with respect to taxes referred to in paragraphs 1(b) and 2 of Article 2 (Taxes Covered). 　　The following two examples illustrate the application of paragraph 2 in the case of a U.S. source portfolio dividend received by a U.S. citizen resident in South Africa. In both examples, the U.S. rate of tax on residents of South Africa under paragraph 2(b) of Article 10 (Dividends) of the Convention is 15 percent. In both examples the U.S. income tax rate on the U.S. citizen is 36 percent. In Example I, assume the South African income tax rate on its resident (the U.S. citizen) is 25 percent (below the U.S. rate), and in Example II, assume the South African rate on its resident is 40 percent (above the U.S. rate). 　　　　　　　　　　　　　　　　　　　　　　　　Example I Example II Paragraph 2(a) U.S. dividend declared 　　　　　　　　　　　　　$100.00 $100.00 Notional U.S. withholding tax per Article 10(2)(b)15.00 15.00 South Africa taxable income 100.00 100.00 South Africa tax before credit 25.00 40.00 South Africa foreign tax credit 15.00 15.00 Net post-credit South Africa tax 10.00 25.00 Example I Example II Paragraphs 2(b) and (c) U.S. pre-tax income $100.00 $100.00 U.S. pre-credit citizenship tax 36.00 36.00 Notional U.S. withholding tax 15.00 15.00 U.S. tax available for credit 21.00 21.00 Income resourced from U.S. to South Africa 27.77 58.33 U.S. tax on resourced income 10.00 21.00 U.S. credit for South African tax 10.00 21.00 Net post-credit U.S. tax 11.00 0.00 Total U.S. tax 26.00 15.00 　　In both examples, in the application of paragraph 2(a), South Africa credits a 15 percent U.S. tax against its residence tax on the U.S. citizen. In example I the net South African tax after foreign tax credit is $10.00; in the second example it is $25.00. In the application of paragraphs 2(b) and (c), from the U.S. tax due before credit of $36.00, the United States subtracts the amount of the U.S. source tax of $15.00, against which no U.S. foreign tax credit is to be allowed. This provision assures that the United States will collect the tax that it is due under the Convention as the source country. In both examples, the maximum amount of U.S. tax against which credit for South African tax may be claimed is $21.00. Initially, all of the income in these examples was U.S. source. In order for a U.S. credit to be allowed for the full amount of South African tax, an appropriate amount of the income must be resourced. The amount that must be resourced depends on the amount of South African tax for which the U.S. citizen is claiming a U.S. foreign tax credit. In example I, the South African tax was $10.00. In order for this amount to be creditable against U.S. tax, $27.77 ($10 divided by .36) must be resourced as foreign source. When South African tax is credited against the U.S. tax on the resourced income, there is a net U.S. tax of $11.00 due after credit. In example II, South African tax was $25 but, because the amount available for credit is reduced under subparagraph 2(c) by the amount of the U.S. source tax, only $21.00 is eligible for credit. Accordingly, the amount that must be resourced is limited to the amount necessary to ensure a foreign tax credit for $21 of South African tax, or $58.33 ($21 divided by .36). Thus, even though South African tax was $25.00 and the U.S. tax available for credit was $21.00, there is no excess credit available for carryover. Paragraph 3 　　Paragraph 3 provides the rules for the South African double taxation relief. Under this paragraph, United States taxes (i.e., the United States taxes listed as covered taxes in Article 2 (Taxes Covered)) paid by South African residents in accordance with the Convention will be allowed as a credit against the South African taxes payable by that resident. Two conditions are specified. U.S. taxes imposed solely by reason of citizenship under the saving clause of paragraph 4 of Article 1 (General Scope) are not covered by this rule. South Africa's obligation with respect to such taxes is dealt with in paragraph 2. The paragraph also specifies that the South African credit shall not exceed the percentage of the South African tax due before the credit, which is the same as the ratio of the U.S. source income in respect of which the credit is being claimed to total South African income. Relation to Other Articles 　　By virtue of the exceptions in subparagraph 5(a) of Article 1 (General Scope) this Article is not subject to the saving clause of paragraph 4 of Article 1. Thus, the United States will allow a credit to its citizens and residents in accordance with the Article, even if such credit were to provide a benefit not available under the Code. 　　　　　　　　　　　　　ARTICLE 24 　　　　　　　　　　　　Non-discrimination 　　This Article assures that nationals of a Contracting State, in the case of paragraph 1, and residents of a Contracting State, in the case of paragraphs 2 through 5, will not be subject, directly or indirectly, to discriminatory taxation in the other Contracting State. For this purpose, non-discrimination means providing national treatment. Not all differences in tax treatment, either as between nationals of the two States, or between residents of the two States, are violations of this national treatment standard. Rather, the national treatment obligation of this Article applies only if the nationals or residents of the two States are comparably situated. 　　Each of the relevant paragraphs of the Article provides that two persons that are comparably situated must be treated similarly. Although the actual words differ from paragraph to paragraph (e.g., paragraph 1 refers to two nationals "in the same circumstances," paragraph 2 refers to two enterprises "carrying on the same activities" and paragraph 3 refers to two enterprises that are "similar"), the common underlying premise is that if the difference in treatment is directly related to a tax-relevant difference in the situations of the domestic and foreign persons being compared, that difference is not to be treated as discriminatory (e.g., if one person is taxable in a Contracting State on worldwide income and the other is not, or tax may be collectible from one person at a later stage, but not from the other, distinctions in treatment would be justified under paragraph 1. Other examples of such factors that can lead to non- discriminatory differences in treatment will be noted in the discussions of each paragraph. 　　The operative paragraphs of the Article also use different language to identify the kinds of differences in taxation treatment that will be considered discriminatory. For example, paragraphs 1 and 3 speak of "any taxation or any requirement connected therewith that is other or more burdensome," while paragraph 2 specifies that a tax "shall not be less favorably levied." Regardless of these differences in language, only differences in tax treatment that materially disadvantage the foreign person relative to the domestic person are properly the subject of the Article. Paragraph 1 　　Paragraph 1 provides that a national of one Contracting State may not be subject to taxation or connected requirements in the other Contracting State that are different from, or more burdensome than, the taxes and connected requirements imposed upon a national of that other State in the same circumstances. As noted above, whether or not the two persons are both taxable on worldwide income is a significant circumstance for this purpose. 　　A national of a Contracting State is afforded protection under this paragraph even if the national is not a resident of either Contracting State. Thus, a U.S. citizen who is resident in a third country is entitled, under this paragraph, to the same treatment in South Africa as a national of South Africa who is in similar circumstances (i.e., who is resident in a third State). The term "national" in relation to a Contracting State is defined in subparagraph 1(f) of Article 3 (General Definitions). 　　Because the relevant circumstances referred to in the paragraph relate, among other things, to taxation on worldwide income, paragraph 1 does not obligate the United States to apply the same taxing regime to a national of South Africa who is not resident in the United States and a U.S. national who is not resident in the United States. United States citizens who are not residents of the United States but who are, nevertheless, subject to United States tax on their worldwide income are not in the same circumstances with respect to United States taxation as citizens of South Africa who are not United States residents. Thus, for example, Article 24 would not entitle a national of South Africa resident in a third country to taxation at graduated rates on U.S. source dividends or other investment income that applies to a U.S. citizen resident in the same third country. 　　The definition of the term "national" is found in Article 3 (General Definitions). The definition covers both individuals and juridical persons that are nationals of a Contracting State. Paragraph 2 　　Paragraph 2 provides that a Contracting State may not tax a permanent establishment or fixed base of an enterprise of the other Contracting State less favorably than an enterprise of that first-mentioned State that is carrying on the same activities. 　　The fact that a U.S. permanent establishment of a South African enterprise is subject to U.S. tax only on income that is attributable to the permanent establishment, while a U.S. corporation engaged in the same activities is taxable on its worldwide income is not, in itself, a sufficient difference to deny national treatment to the permanent establishment. There are cases, however, where the two enterprises would not be similarly situated and differences in treatment may be warranted. For instance, it would not be a violation of the non-discrimination protection of paragraph 2 to require the foreign enterprise to provide information in a reasonable manner that may be different from the information requirements imposed on a resident enterprise, because information may not be as readily available to the Internal Revenue Service from a foreign as from a domestic enterprise. Similarly, it would not be a violation of paragraph 2 to impose penalties on persons who fail to comply with such a requirement (see, e.g., sections 874(a) and 882(c)(2)). Further, a determination that income and expenses have been attributed or allocated to a permanent establishment in conformity with the principles of Article 7 (Business Profits) implies that the attribution or allocation was not discriminatory. 　　Section 1446 of the Code imposes on any partnership with income that is effectively connected with a U.S. trade or business the obligation to withhold tax on amounts allocable to a foreign partner. In the context of this Convention, this obligation applies with respect to a share of the partnership income of a South African partner and attributable to a U.S. permanent establishment. There is no similar obligation with respect to the distributive shares of U.S. resident partners. It is understood, however, that this distinction is not a form of discrimination within the meaning of paragraph 2 of the Article. No distinction is made between U.S. and non- U.S. partnerships, since the law requires that partnerships of both U.S. and non-U.S. domicile withhold tax in respect of the partnership shares of non-U.S. partners. Furthermore, in distinguishing between U.S. and non-U.S. partners, the requirement to withhold on the non-U.S. but not the U.S. partner's share is not discriminatory taxation, but, like other withholding on nonresident aliens, is merely a reasonable method for the collection of tax from persons who are not continually present in the United States, and as to whom it otherwise may be difficult for the United States to enforce its tax jurisdiction. If tax has been over-withheld, the partner can, as in other cases of over-withholding, file for a refund. (The relationship between paragraph 2 and the imposition of the branch tax is dealt with below in the discussion of paragraph 6.) 　　Paragraph 2 obligates the host State to provide national treatment not only to permanent establishments of an enterprise of the other State, but also to other residents of such State that are taxable in the host State on a net basis because they derive income from independent personal services performed in the host State that is attributable to a fixed base in that State. Thus, an individual resident of South Africa who performs independent personal services in the U.S., and who is subject to U.S. income tax on the income from those services that is attributable to a fixed base in the United States, is entitled to no less favorable tax treatment in the United States than a U.S. resident engaged in the same kinds of activities. With such a rule in a treaty, the host State cannot tax its own residents on a net basis, but disallow deductions (other than personal allowances, etc., as provided in paragraph 4) with respect to the income attributable to the fixed base. Paragraph 3 　　Paragraph 3 requires that a Contracting State not impose taxation or connected requirements on an enterprise of that State that is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, that is other or more burdensome than the taxation or connected requirements that it imposes on other similar enterprises of that first-mentioned Contracting State. For this purpose it is understood that "similar" refers to similar activities or ownership of the enterprise. 　　The Tax Reform Act of 1986 changed the rules for taxing corporations on certain distributions they make in liquidation. Prior to 1986, corporations were not taxed on distributions of appreciated property in complete liquidation, although nonliquidating distributions of the same property, with several exceptions, resulted in corporate-level tax. In part to eliminate this disparity, the law now generally taxes corporations on the liquidating distribution of appreciated property. The Code provides an exception in the case of distributions by 80 percent or more controlled subsidiaries to their parent corporations, on the theory that the built-in gain in the asset will be recognized when the parent sells or distributes the asset. This exception does not apply to distributions to parent corporations that are tax-exempt organizations or, except to the extent provided in regulations, foreign corporations. The policy of the legislation is to collect one corporate-level tax on the liquidating distribution of appreciated property. If, and only if, that tax can be collected on a subsequent sale or distribution does the legislation defer the tax. It is understood that the inapplicability of the exception to the tax on distributions to foreign parent corporations under section 367(e)(2) does not conflict with paragraph 3 of the Article. While a liquidating distribution to a U.S. parent will not be taxed, and, except to the extent provided in regulations, a liquidating distribution to a foreign parent will, paragraph 3 merely prohibits discrimination among corporate taxpayers on the basis of U.S. or foreign stock ownership. Eligibility for the exception to the tax on liquidating distributions for distributions to nonexempt, U.S. corporate parents is not based upon the nationality of the owners of the distributing corporation, but rather is based upon whether such owners would be subject to corporate tax if they subsequently sold or distributed the same property. Thus, the exception does not apply to distributions to persons that would not be so subject -- not only foreign corporations, but also tax-exempt organizations. A similar analysis applies to the treatment of section 355 distributions subject to section 367(e)(1). 　　For the reasons given above in connection with the discussion of paragraph 2 of the Article, it is also understood that the provision in section 1446 of the Code for withholding of tax on non-U.S. partners does not violate paragraph 3 of the Article. 　　It is further understood that the ineligibility of a U.S. corporation with nonresident alien shareholders to make an election to be an ?S" corporation does not violate paragraph 3 of the Article. If a corporation elects to be an S corporation (requiring 35 or fewer shareholders), it is generally not subject to income tax and the shareholders take into account their pro rata shares of the corporation's items of income, loss, deduction or credit. (The purpose of the provision is to allow an individual or small group of individuals to conduct business in corporate form while paying taxes at individual rates as if the business were conducted directly.) A nonresident alien does not pay U.S. tax on a net basis, and, thus, does not generally take into account items of loss, deduction or credit. Thus, the S corporation provisions do not exclude corporations with nonresident alien shareholders because such shareholders are foreign, but only because they are not net-basis taxpayers. Similarly, the provisions exclude corporations with other types of shareholders where the purpose of the provisions cannot be fulfilled or their mechanics implemented. For example, corporations with corporate shareholders are excluded because the purpose of the provisions to permit individuals to conduct a business in corporate form at individual tax rates would not be furthered by their inclusion.