ARTICLE 7

Business Profits

This Article provides the rules for the taxation by a Contracting State of the business profits of an enterprise of the other Contracting State. The general rule is found in paragraph 1, that business profits (as defined in paragraph 7) of an enterprise of one Contracting State may not be taxed by the other Contracting State unless the enterprise carries on business in that other Contracting State through a permanent establishment (as defined in Article 5 (Permanent Establishment)) situated there. Where that condition is met, the State in which the permanent establishment exists may tax the income of the enterprise, but only so much of the income as is attributable to the permanent establishment. This differs from the comparable rule in the 1954 Convention, which contained a limited force of attraction rule. That rule permitted the State in which the permanent establishment is located to tax income of the enterprise even if not attributable to the permanent establishment, if the income is derived from sources in that State from the sale of goods or merchandise of the same kind as that sold through the permanent establishment or from other transactions of the same kind as those effected through the permanent establishment.

Paragraph 2 provides rules for the proper attribution of business profits to a permanent establishment. It provides that the Contracting States will attribute to a permanent establishment the profits which it would have earned had it been an independent entity, engaged in the same or similar activities under the same or similar circumstances. The computation of the business profits attributable to a permanent establishment under this paragraph is subject to the rules of paragraph 3 for the allowance of expenses incurred for the purposes of earning the income. The profits attributable to a permanent establishment may be from sources within or without a Contracting State. Thus, certain items of foreign source income described in section 864(c)(4)(B) of the Code may be attributed to a U.S. permanent establishment of a German enterprise and subject to tax in the United States. The concept of "attributable to" in the Convention is narrower than the concept of "effectively connected" in section 864(c) of the Code. The limited "force of attraction" rule in Code section 864(c)(3), therefore, is not applicable under the Convention.

Paragraph 4 of the Protocol elaborates on paragraphs 1 and 2 of Article 7, and on paragraph 3 of Article 13 (Gains). This Protocol paragraph incorporates the rule of Code section 864(c)(6) into the Convention. Like the Code section on which it is based, Paragraph 4 of the Protocol provides that any income or gain attributable to a permanent establishment (or, in the context of Article 13, a fixed base as well) during its existence is taxable in the Contracting State where the permanent establishment (or fixed base) is situated even if the payments are deferred until after the permanent establishment (or fixed base) no longer exists. The Protocol provision goes beyond the Code section on which it is based by clarifying that expenses attributable to the permanent establishment (or fixed base) during its existence may be deducted from the deferred income at such time as that income is subject to tax.

Paragraph 5 of the Protocol incorporates into Articles 7 and 13 of the Convention a rule similar to that of Code section 864(c)(7). Under the Code rule, if an asset which had been part of the business property of a U.S. trade or business (or, in a treaty context, of a permanent

establishment or fixed base in the United States) is alienated within ten years of its removal from the U.S. trade or business (or permanent establishment/fixed base), the gain realized on such alienation is subject to U.S. tax. Under Paragraph 5 of the Protocol, a right of the Contracting State in which the permanent establishment (or fixed base) exists or existed to tax such gains is confirmed, but the taxable gain is limited to that portion which accrued during the time that the asset formed part of the business property of the permanent establishment (or fixed base). The tax may be imposed under the Convention if the alienation occurs within ten years of the date on which the property ceased to be part of the business property of the permanent establishment (or fixed base). If, however, the laws of either Contracting State provide for a look-back period shorter than ten years, that shorter period will al)ply with respect to the tax of both Contracting States under the Convention. This rule in Paragraph 5 of the Protocol combines certain features of the laws of both the United States and Germany. It limits German law by imposing the ten year limit of U.S. law on either Contracting State's right to tax such gains, and it restricts U.S. law by limiting the taxable gain, as under German law, to the gain which accrued while the property formed part of the business property of the permanent establishment (or fixed base).

Paragraph 3 provides that in determining the business profits of a permanent establishment, deductions shall be allowed for expenses incurred for the purposes of the permanent establishment. Deductions are to be allowed regardless of where the expenses are incurred. The paragraph specifies that among the expenses referred to which are incurred for the purposes of the permanent establishment are expenses for research and development, interest and other similar expenses. Also included is a reasonable amount of executive and general administrative expenses. The language of this paragraph differs in minor respect from that in the U.S. Model. The U.S. Model refers to a "reasonable allocation" of the enumerated expenses; this paragraph in the Convention omits this reference. During the negotiations, the German delegation observed that the U.S. Model language seems to require both Contracting States to apply the sorts of expense allocations that are found in U.S. law, as, for example, in regulation sections 1.861-8 and 1.882-5. Leaving out the reference to "reasonable allocation" is understood to make clear that each State may use its own rules, whether tracing or allocation rules, for attributing expenses to a permanent establishment.

Paragraph 6 of the Protocol refers to paragraph 3 of Article 7 of the Convention. The Protocol Paragraph provides that the competent authorities may by mutual agreement determine common procedures for allocating expenses to a permanent establishment which may differ from the procedures used under the laws of the Contracting States. The language of this Paragraph of the Protocol reinforces the point made in the preceding paragraph of this explanation, that (in the absence of a mutual agreement to the contrary) the Contracting States may under the Convention use their own internal law rules for determining the expenses which are to be allowed as deductions in calculating the income of a permanent establishment.

Paragraph 4 provides that no business profits will be attributed to a permanent establishment merely because it purchases goods or merchandise for the enterprise of which it is a permanent establishment. This rule refers to a permanent establishment which performs more than one function for the enterprise, including purchasing. For example, the permanent establishment may purchase raw materials for the enterprise's manufacturing operation and sell the manufactured output, while business profits may be attributable to the permanent

establishment with respect to its sales activities, no profits are attributable with respect to its purchasing activities. If the sole activity were the purchasing of goods or merchandise for the enterprise the issue of the attribution of income would not arise, because, under subparagraph 4(d) of Article 5 (Permanent Establishment), there would be no permanent establishment.

Paragraph 5 states that the business profits attributed to a permanent establishment are only those derived from its assets or activities. This clarifies the fact, as noted in connection with paragraph 2 of the Article, that the Code concept of effective connection, with its limited "force of attraction", is not incorporated into the Convention.

Paragraph 6 explains the relationship between the provisions of Article 7 and other provisions of the Convention. Under paragraph 6, where business profits include items of income that are dealt with separately under other articles of the Convention, the provisions of those articles will, except where they specifically provide to the contrary, take precedence over the provisions of Article 7. Thus, for example, the taxation of interest will be determined by the rules of Article 11 (Interest), and not by Article 7, except where, as provided in paragraph 3 of Article 11, the interest is attributable to a permanent establishment, in which case the provisions of Article 7 apply.

Paragraph 7 specifies that the term "business profits" as used in the Convention includes two classes of income which, in some countries, are subject to gross basis taxation at source and in the OECD Model Convention are treated as royalties under Article 12. These are income from the rental of tangible personal property and income from the rental or licensing of motion picture films or works on film, tape or other means of reproduction for use in radio or television broadcasting. The inclusion of these classes of income in business profits means that such income earned by a resident of a Contracting State can be taxed by the other Contracting State only if the income is attributable to a permanent establishment maintained by the resident in that other State, and, if the income is taxable, it can be taxed only on a net basis. The comparable provision in the U.S. Model also provides a general definition which says that the term "business profits" means income derived from any trade or business. The absence of this definition from the Convention does not indicate any difference in the meaning to be attributed to the term.

This Article is subject to the saving clause of subparagraph (a) of Paragraph 1 of the Protocol. Thus, if, for example, a citizen of the United States who is a resident of Germany derives business profits from the United States which are not attributable to a permanent establishment in the United States, the United States may, subject to the special foreign tax credit rules of paragraph 3 of Article 23 (Relief from Double Taxation), tax those profits as part of the worldwide income of the citizen, notwithstanding the provisions of this Article under which such income derived by a resident of Germany is exempt from U.S. tax.