Article 11 provides rules — U.S. Income Tax Treaty

Paragraph 1 grants to the residence State the right to tax interest derived and beneficially owned by its residents.

Paragraph 2 grants to the source State the right to tax the interest payment. However, if the beneficial owner of the interest is a resident of the other Contracting State, the amount of the tax is limited to:

(a) 10 percent of the gross amount of the interest that is paid on a loan granted by a bank carrying on a bona fide banking business or by a similar financial institution (including an insurance company); and

(b) 15 percent of the gross amount of the interest in all other cases.

The term "beneficial owner" is not defined in the Convention; it is, instead, defined by domestic law of the Contracting States. A nominee or agent which is a resident of a Contracting State may not claim the benefits of this Article if the interest is received on behalf of a person who is not a resident of that Contracting State. However, interest received by a nominee for the benefit of a resident would qualify for the benefits of this Article.

Paragraph 2 differs from the comparable provision in the U.S. Model, which provides that only the residence State may tax interest derived and beneficially owned by a resident of a Contracting State, unless the interest is attributable to a permanent establishment or fixed base of the beneficial owner in the other Contracting State.

Paragraph 3 provides exceptions from the rule of paragraph 2 that allows a source country to tax. The exceptions apply to interest that is included in any of three categories. The first category of interest that is exempt from tax in the source State is interest that is derived and beneficially owned by the Government of the other Contracting State, a political subdivision or local authority thereof, the Reserve Bank of India, or the Federal Reserve Banks of the United States, as the case may be, and such other institutions of either Contracting State as the competent authorities may agree pursuant to Article 27 (Mutual Agreement procedure). The second category of interest that is exempt from tax in the source State is interest with respect to loans or credits extended or endorsed by the Export-Import Bank of the United States when the interest arises in India and by the EXIM Bank of India when the interest arises in India.

The third category of interest that is exempt from tax in the source State is interest derived and beneficially owned by a resident of the other Contracting State other than a person referred to in the first or second category if the transaction giving rise to the debt-claim has been approved in this behalf by the Government of the source State. The Indian delegation explained that a lender may apply to the Government of India for approval of the tax exemption. This category of interest is exempt under the Indian tax statute.

Paragraph 4 defines the term "interest" as used in Article 11 to include, inter alia, income from debt claims of every kind, whether or not secured by a mortgage, and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities, and income from bonds or debentures, including premiums or prizes attaching to such securities, bonds, or debentures.

Penalty charges for late payment are excluded from the definition of interest. Income dealt within Article 10 (Dividends) is also excluded from the definition of interest. Thus, for example, income from a debt obligation carrying the right to participate in profits is not covered by Article 11 to the extent characterized as a dividend under the laws of the Contracting State in which the income arises. The definition of interest in the Convention differs from the definition of interest in the U.S. Model only as to the exclusion of amounts characterized as dividends under Article 10.

Paragraph 5 limits the right of one Contracting State to impose a gross bas 5 tax on interest payments where the beneficial owner of the interest is a person that is a resident of the other Contracting State. A gross basis tax may not be imposed if

(1) the person carries on a business in the Contracting State in which the interest arises through a permanent establishment situated there or performs in the Contracting State in which the interest arises independent personal services from a fixed base situated here and

(2) the interest is attributable to such permanent establishment or fixed base. In such cases the provisions of Article 7 (Business Profits) or Article 15 (Independent Personal Services)

will apply.

Paragraph III of the Protocol elaborates on paragraph 5 by incorporating the principle of Code section 864(c)(6) into the Convention. Like the Code section on which it is based, Paragraph III of the Protocol provides that any annual income or gain attributable to a permanent establishment or fixed base 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.

Paragraph 6 provides a source rule for interest. It provides that interest shall be deemed to arise in a Contracting State when the payer is that State itself or a political subdivision, local authority, or resident of that State. The exception to the general rule that interest is sourced in the State of the payer's residence is the case in which the payer of the interest carries on business through a permanent establishment in the other State or performs independent personal services from a fixed base situated in the other State and the interest is borne by such permanent establishment or fixed base.

Thus, under Article 11 the United States may tax interest that is paid by a U.S. trade or business of a foreign corporation in the United States and attributable to the corporation's permanent establishment in the United States. As U.S. source interest paid, the interest is subject to tax at the rate provided in paragraph 2 when the beneficial owner is a resident of India. The tax allowed under the Convention on the excess interest of a corporation resident in India is not considered interest paid. The tax on excess interest is described in and subject to limitations of Article 14 (Permanent Establishment Tax).

Paragraph 7 provides that, in the case of interest paid by a person with a special relationship to the beneficial owner of the interest, Article 11 applies only to interest payments that would have been made absent such special relationship (i.e., an arm's length interest payment). Any excess amount of interest paid remains taxable according to the laws of the United States and India, respectively, with due regard to the other provisions of the Convention. Thus, for example, if the excess amount would be treated as a distribution of profits, such amount could be taxed as a dividend rather than as interest, but the tax would be subject to the rate limitations of paragraph 2 of Article 10 (Dividends).

Notwithstanding the limitations under Article 11 on source country taxation of interest, the saving clause of paragraph 3 of Article 1 (General Scope) permits the United States to tax its residents and citizens as if the Convention had not come into force.