ing income from debt-claims) that is dealt with under Article 10 (Dividends).

The proposed treaty provides a source rule for interest (which is also used in Article 25 (Relief from Double Taxation) for foreign tax credit purposes). Interest is sourced within a country if the payor is the government of that country, including political subdivisions and local authorities, or a resident of that country. Howev er, if the interest is borne by a permanent establishment (or fixed base) that the payor has in India or the United States and the indebtedness is incurred with respect to that permanent establishment (or fixed base), interest has its source in that country, regardless of the residence of the payor. Generally, this is consistent with U.S. source rules (Code secs. 861-862), which provide that interest income is sourced in the country in which the payor is resident, and with the effect of the branch-level interest rules (Code sec. 884(f)(1)(A)), which subject interest paid to a foreign person by the U.S. branch of a foreign corporation to the U.S. withholding tax rules. Thus, for example, if a Swiss resident with a permanent establishment in India incurs indebtedness to a U.S. person for that Indian permanent establishment, and the permanent establishment bears the interest, then the interest has its source in India. The proposed treaty addresses the issue of non-arm's-length interest charges between parties having a direct or indirect special relationship by providing that the amount of interest for purposes of the treaty is the amount of arm's-length interest. The amount of interest in excess of the arm's-length interest is taxable according to the laws of each country, taking into account the other provisions of the treaty (e.g., excess interest paid to a shareholder may be treated as a dividend under local law and thus entitled to the benefits of Article 10 of the treaty).

As in the case of dividends, under the saving clause of Article 1(3) (General Scope) the United States may always tax its citizens on their interest income (subject to any applicable foreign tax credit), even if they are resident in India.

ARTICLE 12. ROYALTIES AND FEES FOR INCLUDED SERVICES

Under the same system that applies to dividends and interest, the United States imposes a 30-percent tax on U.S. source royalties paid to foreign persons. Royalties are from a U.S. source if they are for the use of property located in the United States. U.S. source royalties include royalties for the use of or the right to use intangibles in the United States, including motion picture royalties. In addition, under the Code, fees for services performed within the United States are subject to tax on a net basis if effectively connected with a U.S. trade or business of a nonresident alien or foreign corporation, or on a gross basis (at the rate of 30 percent) only if not so effectively connected.

The Committee understands that India imposes a 30-percent tax on the gross amount of royalties as well as on the gross amount of a broad range of service fees (fees for technical, managerial, or consultancy services performed anywhere) paid by residents of India.

Royalties

The U.S. model treaty exempts royalties from tax at source. The proposed treaty, however, allows limited source-basis taxation of royalties. Royalties from sources in one country (determined under the royalty source rule discussed below) that are beneficially owned by a resident of the other country may be taxed by both countries. The maximum rate of source-basis taxation is generally 15 percent or 10 percent, depending on the type of property with respect to which the royalty is paid. In some cases a temporary 20-percent rate may apply. If a payment is received as a royalty of the first type defined below, it may be taxed in the source country at a rate that generally may not exceed 15 percent. However, during the first five years that the treaty is in effect, the 15-percent rate only applies to royalties paid by the Government, a political subdivision, or a public sector company of the source country; all other royalties of the first type may be taxed by the source country at the rate of 20 percent during that five-year period. If a payment is received as a royalty of the second type defined below, it may be taxed by the source country at a rate that may not exceed 10 percent.

The proposed treaty defines two types of "royalties" in paragraph 3 of Article 12. First, "royalties" are defined as payments of any kind received as a consideration for the use of, or the right to use, any copyright of a literary, artistic, or scientific work, including cinematographic films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting; any patent, trademark, design or model, plan, secret formula or process; or for information concerning industrial, commercial or scientific equipment, including gains derived from the alienation of any such right or property which are contingent on the productivity, use or disposition of such right or property. Second, "royalties" are defined also to include payments of any kind received as a consideration for the use of, or the right to use, any industrial, commercial or scientific equipment (other than such payments as are exempt from source country taxation under the provisions of Article 8 (Shipping and Air Transport)).

The treaty's royalty definition roughly follows that of the OECD and United Nations model treaties. The royalty definition in the proposed treaty differs from the corresponding definition in the U.S. model treaty in that royalties under the proposed treaty (1) include payments for property rights related to cinematographic films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, but (2) do not include payments in respect of "other like right or property" in addition to the enumerated property rights of patent, trademark, design or model, plan, secret formula or process. Definitions similar to those in the proposed treaty have been included in other recent

* As discussed in Treasury's technical explanation of the proposed treaty, the term "information concerning industrial, commercial, or scientific experience" alludes to the concept of knowhow and means information that is not publicly available and that cannot be known from mere examination of a product and mere knowledge of the progress of technique. As provided in the Commentaries on the Articles of the OECD Model Convention (paragraph 12 of the Article 12 Commentaries): "In the know-how contract, one of the parties agrees to impart to the other, so that he can use them for his own account, his special knowledge and experience which remain unrevealed to the public."

U.S. income tax treaties, such as those with Australia, Jamaica, and Barbados.

Fees for included services

Unlike the U.S. model treaty, the proposed treaty treats certain "fees for included services" in the same manner as royalties. The proposed treaty, like the U.S. model, treats other income from services in articles 7 and 15-22. The proposed treaty (in paragraph 4 of Article 12) defines fees for included services generally to mean payments of any kind to any person in consideration for the rendering of any technical or consultancy services (including through the provision of services of technical or other personnel) if such services either (a) are ancillary and subsidiary to the application or enjoyment of the right, property or information for which a royalty payment is received; or (b) make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design. However, paragraph 5 of Article 12 lists specific exclusions from the definition of fees for included services, for any amounts paid:

(a) for services that are ancillary and subsidiary, as well as inextricably and essentially linked, to the sale of property other than a contingent sale where the gain is treated as a royalty under the treaty;

(b) for services that are ancillary and subsidiary to the rental of ships, aircraft, containers or other equipment used in connection with the operation of ships or aircraft in international traffic;

(c) for teaching in or by educational institutions;

(d) for services for the personal use of the individual or individuals making the payment; or

(e) to an employee of the person making the payments or to any individual or firm of individuals (other than a company) for professional services as defined in Article 15 (Independent Personal Services). Thus, a payment to an individual or firm of individuals, such as a partnership, for professional services is subject to tax only under Article 15 and is not subject to tax under Article 12.

Fees for included services that are ancillary and subsidiary to the enjoyment of property for which a royalty of the second type is received are subject to the same 10-percent maximum tax rate as royalties of the second type. All other fees for included services are subject to the same 15- or 20-percent maximum tax rate as royalties of the first type.

The treatment of service fees provided in the proposed treaty is a departure from the domestic law of both the United States and India. The Committee understands that, under Indian statutory law, a broad range of service fees (fees for technical, managerial, or consultancy services performed anywhere) is subject to a 30-percent gross basis tax. Under U.S. statutory law, fees for services performed within the United States are subject to tax on a net basis if effectively connected with a U.S. trade or business of a nonresident alien or foreign corporation, or on a gross basis (at the rate of 30 percent) only if not so effectively connected. Paragraph IV of the proposed protocol (Ad Article 12) clarifies that, if fees for included services may be taxed by the United States under Article 12 but are subject to net basis taxation under internal U.S. law, the level

of that net basis taxation (or, where applicable, the sum of that net basis tax and the amount of the tax allowable under paragraph 1 of Article 14 (Permanent Establishment Tax) with respect to those fees) is not to exceed the gross basis tax at the limited rates imposed under Article 12. The term "fees for included services" is not defined (apart from the proposed treaty) in the domestic laws of either country.

Rules applicable to both royalties and fees

The treaty limitations on source country royalty or fee taxation apply only if the royalty or fee is beneficially owned by a resident of the other country; they do not apply if the recipient is a nominee for a nonresident. They also do not apply if the recipient is an enterprise carrying on business through a permanent establishment in the source country or an individual performing personal services in an independent capacity through a fixed base in the source country, and the royalty or fee is attributable to the permanent establishment or fixed base. Royalties and fees that are attributable to a permanent establishment or fixed base are taxed as business profits (Article 7) or as income from the performance of independent personal services (Article 15), even if the royalty or fee is deferred until the permanent establishment or fixed base has ceased to exist (pursuant to Paragraph III of the proposed protocol). The proposed treaty provides a special source rule for royalties and fees. As explained below in connection with Article 25 (Relief from Double Taxation), this source rule applies for purposes of the foreign tax credits of domestic residents as well as for purposes of the taxation of nonresidents. Generally, as indicated above, under U.S. tax rules (Code secs. 861-62), royalty income is sourced where the property or right is being used and income from the performance of services is sourced where the services are performed. Under the proposed treaty, if a royalty or fee is paid by the Government of one of the countries, including political subdivisions and local authorities, or by a resident of one of the countries, then the royalty or fee generally is sourced in the country of residence of the payor. However, if the payor has a permanent establishment or fixed base in one of the countries in connection with which the obligation to pay the royalty or fee was incurred, and if the royalty or fee is borne by the permanent establishment or fixed base, then the royalty or fee arises in the country in which the permanent establishment or fixed base is situated, regardless of the residence of the payor. This provision is also found in the United Nations model treaty.

In the case of any royalty or fee not covered by the just-described source rule, a royalty is sourced in the country in which the property or right is used, and a fee is sourced in the country in which the services are performed. Thus, the proposed treaty's source rules override the United States' statutory "place of use" and "place of performance" source rules in the case of any conflict. For example, if a U.S. resident licenses a patent to a resident of India (or in connection with a permanent establishment located in India which bears the royalty payment), the treaty provides that the royalty is sourced in (and taxable by) India. Even if the patent is used within the United States, notwithstanding the statutory source rules of

the United States, the royalty is sourced in India under the proposed treaty.

The proposed treaty addresses the issue of non-arm's-length royalties or fees between related parties (or parties having an otherwise special relationship) by providing that the amount of royalties or fees for purposes of applying this article is the amount of arm'slength royalties or fees. Any amount of royalties or fees paid in excess of the arm's-length royalty or fee is taxable according to the laws of each country, taking into account the other provisions of the proposed treaty. For example, excess royalties paid to a parent corporation may be treated as dividends under local law and thus be treated under Article 10 of the proposed treaty.

As in the case of dividends and interest, under the saving clause of Article 1(3) (General Scope) the United States may always tax its citizens on their royalty or fee income (subject to any applicable foreign tax credit, as modified under the treaty), even if they are resident in India.

Memorandum of Understanding

In general.-A memorandum of understanding was developed by the negotiators indicating how the provisions of Article 12 relating to the scope of "included services" are to be understood both by the competent authorities and by taxpayers in the two countries. As explained in Notes signed the same day as the proposed treaty and exchanged by the Governments of the United States and India, this memorandum of understanding represents the views of the Governments of both countries when the proposed treaty was signed. Both Governments anticipated that, as the competent authorities and taxpayers gain more experience with the concept of fees for included services, further guidance would be developed and made public. The memorandum of understanding describes in some detail the category of services included in the proposed treaty's definition of fees for included services (Article 12). It also provides examples of services intended to be covered within the definition of included services and those intended to be excluded, either because they do not satisfy the general definition or because they are specifically excluded by Article 12. The examples in either case are not intended as an exhaustive list but rather as illustrating a few typical cases. For ease of understanding, the examples in the memorandum describe U.S. persons providing services to Indian persons, but the rules of Article 12 are reciprocal in application.

The memorandum of understanding first defines the terms "technical services" and "consultancy services," which are the only types of services that, assuming other criteria are satisfied, may be considered "included services" under the general definition (paragraph 4 of Article 12). A technical service means a service requiring expertise in a technology. A consultancy service means an advisory service. These two categories are to some extent overlapping because a consultancy service could also be a technical service. However, the category of consultancy services also includes advisory services that do not require expertise in a technology.

Technical and consultancy services may be considered included services only if (a) they are ancillary and subsidiary to the application or enjoyment of a right, property or information for which a