Article IX of the Protocol adds — U.S. Income Tax Treaty

Article 14A provides for the imposition by the United States of a branch tax, both on the "dividend equivalent amount" and on "excess interest", and the imposition by Israel of a comparable tax should Israeli law be amended in the future to impose such a tax. Paragraph (1) of Article 14 confirms the right of each of the Contracting States to impose on a resident of the other, a tax in addition to the tax allowable under the other provisions of the Convention.

The bases of the U.S. taxes are described in subparagraph (a) of paragraph 2. The "dividend equivalent amount" is described in sub-subparagraph (i) and the excess interest that is subject to U.S. tax is described in sub-subparagraph (ii). The Convention does not define the term "dividend equivalent amount". It is, therefore, understood to have the same meaning as in section 884(b) of the Code and the regulations thereunder. Generally the dividend equivalent

amount is the earnings and profits of the foreign corporation (i.e., the profits of the corporation after certain adjustments including a reduction for U.S. corporate income tax) that are effectively connected with the conduct of its trade or business in the United States, decreased by any increase during the taxable year in the corporation's U.S. assets less liabilities ("U.S. net equity") or increased by any decrease in its U.S. net equity. Under the Convention the dividend equivalent amount 15 subject to U.S. tax only to the extent it is attributable to a U.S. permanent establishment.

Under the Convention, the dividend equivalent amount for any year approximates the dividend that a U.S. branch office would have paid its home office during the year if the branch had been operated as a separate U.S. subsidiary company. The dividend equivalent amount is determined taking into account not only effectively connected earnings and profits (or profits that are deemed to be effectively connected) that are attributable to a permanent establishment in the United States but also most profits from the disposition or operation of real estate that are subject to net basis income taxation in the United States under Article 7 (Income From Real Property)) or Article 15 (Capital Gains). Thus, the United States may impose its branch profits tax on the earnings and profits of an Israeli corporation attributable to a permanent establishment in the United States and on the earnings and profits that, in accordance with the Convention, are subject to taxation under U.S. internal law on a net basis either because the Israeli corporation has elected under Code section 882(d) to treat income from real property not otherwise taxed on a net basis as effectively connected income or because the income is gain that is taxable on a net basis, e.g., because it is attributable to the disposition of a United States Real Property Interest (other than an interest in a United States Real Property Holding Corporation).

Subparagraph (ii) of subparagraph (a) provides for the imposition of the U.S. tax on excess interest. Under section 884(f)(l)(B) of the Code, excess interest is the excess of the total amount allowable as a deduction in computing the U.S. effectively connected income of a foreign corporation over the total interest paid by the foreign corporation's U.S. trade or business. Under the Convention, the tax on excess interest applies only to the excess of interest that is deductible in computing

(i) the U.S. tax on income attributable to a permanent establishment of an Israeli corporation in the United States and

(ii) the U.S. tax on income or gain from real property (although not including, under current U.S. law, gain on shares in a United States Real Property Holding Corporation) over the interest paid by the foreign corporation's U.S. permanent establishment.

Israel does not impose a comparable tax on a dividend equivalent amount or on excess interest under current law. Subparagraph (b) of paragraph (2), however, permits Israel to impose a tax comparable to the U.S. tax described in paragraph (a) should Israeli law, in the future, be amended to provide such a tax. The permitted Israeli tax could be imposed on an Israeli branch of a U.S. Corporation such that the branch would be taxed in a manner comparable to a similarly situated Israeli subsidiary and its U.S. parent corporation. The language of the Article permits the tax to be imposed on an Israeli branch, rather than a permanent establishment, because Israel was reluctant to limit its future flexibility in designing a tax. However, as explained in paragraph 11 of the Exchange of Notes, Israel has agreed that, if Israel should, at some time in the future,

impose a tax under subparagraph (b) of this Article in circumstances where the United States would not impose a tax under subparagraph (a), the competent authorities will consult with a view to conforming the two countries' rules under the Convention. Paragraph 11 of the Exchange of Notes states a further understanding that if a resident of a Contracting State qualifies for benefits under the Convention (i.e., the resident satisfies one or more of the tests of Article 25 (Limitation on Benefits)) that person will not be subject to the branch tax imposed by the other Contracting State, except as provided in the Convention. This merely confirms to Israel the result under U.S. law that the "qualified residence" rules of Code section 884(e)(4) do not override the Limitation on Benefits rules of the Convention to deny branch tax benefits to a resident of Israel in circumstances where Convention's benefits would have been allowed under Article 25.

Paragraph (3) specifies the rates at which the taxes described in paragraph (2) may be imposed. Under subparagraph (a), the rate applicable in the United States to the tax on dividend equivalent amount may not exceed 12.5 percent. This is the general rate provided for in paragraph (2) of Article 12 (Dividends) applicable to direct investment dividends. Under subparagraph (b), the maximum rate of U.S. tax on excess interest is 5 percent. The rate should approximate the rate at which interest derived by a resident of Israel from U.S. sources is taxed by the United States. The 5 percent rate in subparagraph (b) represents a "blended rate", reflecting the fact that under Article 13 (Interest) subject to source country tax at a variety of rates varying from zero to 17.5 percent on gross interest, or at regular graduated rates on interest less expenses. Subparagraph (c) provides that, in the event that Israel imposes a tax of the type dealt with in Article 14A, the rate will not exceed the rate applicable in the United States under subparagraphs (a) and (b) on analogous classes of income.