ARTICLE 7. BUSINESS PROFITS

U.S. Code rules

U.S. law distinguishes between the business income and the investment income of a nonresident alien or foreign corporation. A nonresident alien or foreign corporation is subject to a flat 30-percent rate (or lower treaty rate) of tax on certain U.S. source income if that income is not effectively connected with the conduct of a trade or business within the United States. The regular individual or corporate rates apply to income (from any source) that is effectively connected with the conduct of a trade or business within the United States.

The taxation of income as business or investment income varies depending upon whether the income is U.S. or foreign. In general, U.S. source periodic income (such as interest, dividends, rents, and wages) and U.S. source capital gains are effectively connected with the conduct of a trade or business within the United States only if the asset generating the income is used in or held for use in the conduct of the trade or business, or if the activities of the trade or business were a material factor in the realization of the income. All other U.S. source income of a person engaged in a trade or business in the United States is treated as effectively connected with the conduct of a trade or business in the United States (thus it is said to be taxed as if it were business income under a limited "force of attraction" rule).

In the case of foreign persons other than insurance companies, foreign source income is effectively connected income only if the foreign person has an office or other fixed place of business in the United States and the income is attributable to that place of business. For such persons, only three types of foreign source income can be effectively connected income: rents and royalties on intangible property derived from the active conduct of a licensing business; dividends or interest derived in the active conduct of a banking, financing, or similar business in the United States (or received by a corporation the principal business of which is trading stocks or securities for its own account); and certain sales income attributable to a U.S. sales office.

The foreign source income of a foreign corporation that is subject to tax under the insurance company provisions of the Code may be treated as U.S.-effectively connected without regard to the foregoing rules, so long as such income is attributable to the U.S. business of the foreign corporation. In addition, the net investment income of such a company which must be treated as effectively connected with the conduct of an insurance business within the United States is not less than an amount based on a combination of asset/liability ratios and rates of return on investments experienced by the foreign person in its worldwide operations and by the U.S. insurance industry.

Trading in stocks, securities, or commodities in the United States for one's own account generally does not constitute a trade or business in the United States, and accordingly, income from those activities is not taxed by the United States as business income. Thus, income from trading through a U.S.-based employee, a resident broker, commission agent, custodian, or other agent, or from trad

ing by a foreign person physically present in the United States is not generally taxed as business income. However, this rule does not apply to a dealer or to a corporation the principal business of which is trading in stocks or securities for its own account.

The Code as amended by the 1986 Act provides that any income or gain of a foreign person for any taxable year which is attributable to a transaction in any other taxable year will be treated as effectively connected with the conduct of a U.S. trade or business if it would have been so treated had it been taken into account in that other taxable year (Code sec. 864(c)(6)). In addition, the Code provides that if any property ceases to be used or held for use in connection with the conduct of a trade or business within the United States, the determination of whether any income or gain attributable to a sale or exchange of that property occurring within 10 years after the cessation of business is effectively connected with the conduct of trade or business within the United States shall be made as if the sale or exchange occurred immediately before the cessation of business (Code sec. 864(c)(7)).

Proposed treaty rules

Under the proposed treaty, business profits of an enterprise of one country are taxable in the other country only if the enterprise carries on business through a permanent establishment situated in the other country. This is one of the basic limitations under the treaty on a country's right to tax income of a resident of the other country. The proposed treaty's rules on business profits follow, in some respects, the provisions of the U.S. model treaty, with exceptions noted below.

The taxation of business profits under the proposed treaty differs from internal U.S. rules for taxing business profits primarily by requiring more than merely being engaged in a trade or business before a country can tax business profits, and by substituting a different limited force of attraction principle for the Code principle described above. Under the proposed treaty, some type of fixed place of business generally must be present in the treaty country. În addition, the business profits must either be attributable to that fixed place of business or be derived from sales or other business activities that are similar to the sales or other activities effected through the permanent establishment. For example, the Committee understands that if a U.S. manufacturer of farm equipment has a permanent sales office in India (constituting a permanent establishment under Article 5), and the company effects a sale in India from its home office, then the profits from that sale can be taxed in India.

Under the treaty, the profits to be attributed to the permanent establishment include only the profits derived from the assets and activities of the permanent establishment. This definition of the "attributable" concept, which is also found in the U.S. model treaty, is similar to the Code language describing the category of income that is actually (as opposed to deemed) effectively connected with a trade or business (Code sec. 863(c)(2)). On the other hand, the proposed treaty's force of attraction principle that permits a treaty country to tax business profits derived from sales or other business activities that are similar to the sales or other activities

effected through a permanent establishment diverges not only from the U.S. model (which has no force of attraction rule), but also from the Code.

For purposes of the proposed treaty, the term "business profits" includes income derived from any trade or business, regardless of whether carried on by an individual, company, partnership, or other person. Income from the furnishing of services and from the rental of tangible personal property is generally included as business profits. However, income from the furnishing of included services (i.e., certain technical or consultancy services) and income from the rental of certain industrial, commercial, or scientific equipment, as defined in Article 12, is not included as business profits, and is instead dealt with only under Article 12 (Royalties). The business profits of a permanent establishment are determined on an arm's-length basis. Thus, there is attributed to a permanent establishment the business profits which might be expected to have been derived by it if it were a distinct and independent entity engaged in the same or similar activities under the same or similar conditions and dealing at arm's length with the enterprise of which it is a permanent establishment, or with any other associated enterprise. For example, this arm's-length rule applies to transactions between the permanent establishment and a branch of the resident enterprise located in a third country. Amounts may be attributed whether they are from sources within or without the country in which the permanent establishment is located.

Unlike the U.S. model treaty, the proposed treaty provides that if the determination of the correct amount of profits attributable to the permanent establishment is impossible or presents exceptional difficulties, the amount of profits attributable to the permanent establishment can be estimated on a reasonable basis in accordance with the principles contained in the Article. The Treasury's technical explanation of the proposed treaty expresses the expectation of the United States that this rule would be applied only in unusual

cases.

In computing taxable business profits, deductions generally are allowed under paragraph 3 of Article 7 for expenses, wherever incurred, that are incurred for the purposes of the permanent establishment. These deductions include a reasonable allocation of executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the purposes of the enterprise, subject, however, to a condition that such deductions are allowed only in accordance with and subject to the limitations of local tax laws. The Committee understands that the tax laws of India limit certain deductions of a permanent establishment for expenses of the head office. The Committee understands that deductions under Indian law for executive and general administrative expenses (not including interest) may not exceed five percent of the adjusted total income of a permanent establishment. As explained in Treasury's technical explanation to the proposed treaty, five percent is viewed by India as an approximate average of head office executive and general administrative expenses incurred by non-Indian companies for the benefit of their Indian permanent establishments. Paragraph II of the proposed protocol (Ad Article 7) recites the understanding of both countries that allow

able deductions for such expenses will be no less than the amount allowable under the Indian Income-tax Act as of the date of signature (September 12, 1989). It is not clear that, under the proposed treaty, an Indian permanent establishment of a U.S. company would be able to deduct for Indian tax purposes the full amount of its head office expenses incurred for the purposes of the permanent establishment.

In computing taxable business profits of a permanent establishment under the proposed treaty, no deductions are allowed for amounts paid (other than in reimbursement of actual expenses) by the permanent establishment to the head office of the enterprise or to any of its other offices, by way of royalties, fees, or other similar payments in return for the use of patents, know-how or other rights, or by way of commissions or other charges for specific services performed or for management, or, except in the case of banking enterprises, by way of interest on money lent to the permanent establishment. Similarly, no account is taken, in the determination of the profits of the permanent establishment, for amounts charged (otherwise than towards reimbursement of actual expenses) by the permanent establishment to the head office of the enterprise or to any of its other offices, by way of royalties, fees, or other similar payments in return for the use of patents, know-how or other rights, or by way of commissions or other charges for specific services performed or for management, or, except in the case of banking enterprises, by way of interest on money lent to the head office of the enterprise or to any of its other offices.

These rules limiting deductions, which are generally consistent with the Code's approach to the taxation of payments to and from the home office, are not found in the U.S. or OECD model treaties, but are patterned after rules contained in the United Nations. model treaty. Similar rules are contained in certain other U.S. income tax treaties with developing countries. Treasury has informed the Committee that, with regard to the above exceptions for banking enterprises, the treaty is not intended to expand the allowable deductions for interest by a foreign bank operating in the United States beyond the deductions that are available under domestic U.S. law (currently provided by Treas. Reg. sec. 1.882-5). Rather, as explained below in connection with Article 14 (Permanent Establishment Tax), these exceptions relate to Indian internal law treatment of such payments.

Business profits are not attributed to a permanent establishment merely by reason of the purchase of merchandise by the permanent establishment for the account of the enterprise. Thus, if a permanent establishment purchases goods for its head office, the business profits attributed to the permanent establishment with respect to its other activities are not increased by a profit element in its purchasing activities. The amount of profits attributable to a permanent establishment must be determined by the same method each year unless there is good and sufficient reason to change the method.

Consistent with the rule of Code section 864(c)(6), described above, paragraph III of the proposed protocol specifically permits a country to tax business profits attributable to a permanent establishment that no longer exists. That is, a country may tax business

profits in a year after a permanent establishment has ceased to exist, if the profits are otherwise attributable to the permanent establishment. For example, income from an installment sale effected through a permanent establishment may be taxed by the country in which the permanent establishment was located, even after the permanent establishment is liquidated.

Where business profits include items of income that are dealt with separately in other articles of the treaty, those other articles, and not this business profits article, govern the treatment of those items of income. Thus, for example, dividends generally are taxed under the provisions of Article 10 and not as business profits, except as provided in paragraph 4 of Article 10.

ARTICLE 8. SHIPPING AND AIR TRANSPORT

As a general rule, the United States taxes the U.S. source income of a foreign person from the operation of ships or aircraft to or from the United States. An exemption from U.S. tax is provided under the Internal Revenue Code for gross income from the operation of ships or aircraft in international traffic derived by foreign persons that are individual residents of or corporations organized in foreign countries that grant equivalent exemptions to U.S. individual residents and corporations. The United States has entered into agreements with a number of countries providing reciprocal exemptions.

Under the proposed treaty, profits derived by an enterprise of one country from the operation in international traffic of ships or aircraft ("shipping profits") are exempt from tax by the other country. International traffic means any transportation by ship or aircraft operated by an enterprise of one country, except if the ship or aircraft is operated solely between places within the other country (Article 3(1)(j) (General Definitions)). The exemption applies whether or not the ships or aircraft are registered in the first country. Thus, for example, India would not tax the income of a U.S. resident operating a Liberian-flag vessel.

The exemption for shipping profits applies to profits derived by an enterprise from the transportation by sea or air of passengers, mail, livestock, or goods carried on by the owners, lessees, or charterers of ships or aircraft, including the sale of tickets for such transportation on behalf of other enterprises, other activity directly connected with such transportation, and the rental of ships or aircraft incidental to any activity directly connected with such transportation. Thus, income of an enterprise from the rental of ships or aircraft constitutes exempt shipping profits only if it is incidental to the operation by the enterprise of ships or aircraft in international traffic. For example, under the proposed treaty income from bareboat leasing is exempt only if it is incidental to the operation by the enterprise of ships or aircraft in international traffic. This provision is narrower than the corresponding provision in the U.S. model treaty, which covers not only rental profits that are incidental to transportation activities of the lessor but also any rental profits derived from the operation of ships or aircraft in internaticnal traffic by the lessee.