Article VII of the Protocol amends — U.S. Income Tax Treaty

of Article VII of the Protocol makes a technical, clarifying amendment to subparagraph (b) of paragraph (2) of Article 12. Subparagraph (b) provides for reduced rates of tax at source for intercorporate dividends under certain circumstances. The amendment clarifies that the rules in the subparagraph apply to dividends paid both by U.S. and Israeli corporations.

Paragraph 2 of Article VII of the Protocol introduces a new paragraph (3) to Article 12 of the Convention, and renumbers the previous paragraphs (3) and (4) of the Convention as paragraphs (4) and (5) respectively. The new paragraph (3) deals with dividends paid by U.S. entities that are Regulated Investment Companies ("RICs") and REITs (subparagraph (a)), and by equivalent conduit organizations in Israel (subparagraph (b)). Dividends paid by RICs are denied the 12.5 percent direct dividend rate and subjected to the 25 percent portfolio dividend rate regardless of the percentage of voting shares held directly by a corporate recipient of the dividend. A dividend paid by a RElT will be taxed in the United States at full statutory rates (30 percent), unless the beneficial owner of the dividend is an individual resident of Israel who owns less that a 10 percent interest in the RElT, in which case he will be taxed at the portfolio dividend withholding rate of 25 percent.

The denial of the 12.5 percent withholding rate at source to all RIC and RElT shareholders, and the denial of the 25 percent rate to most shareholders of REITs is intended to prevent the use of these conduit entities to gain unjustifiable benefits for certain shareholders. For example, an Israeli corporation that wishes to hold a diversified portfolio of U.S. corporate shares may hold the portfolio directly and pay a U.S. withholding tax of 25 percent on all of the dividends that it receives. Alternatively, it may place the portfolio of U.S. stocks in a RIC, in which the Israeli corporation owns most of the shares, but in which the corporation has arranged to have a sufficient number of small shareholders to satisfy the RIC diversified ownership requirements. Since a RIC generally pays no corporate-level U.S. income tax there is no U.S. tax cost to the Israeli corporation of interposing the RIC as an intermediary in the chain of ownership. That interposition has, however, absent the special rule in paragraph (3), served to transform portfolio dividends, taxable in the United States under the Convention at 25 percent

into direct investment dividends, taxable at only 12.5 percent.

Similarly, a resident of Israel may hold U.S. real property directly, and pay U.S. tax either at a 30 percent rate on the gross income or, generally, at a 31 or 35 percent on the net income. As in the preceding example, by placing the real estate holding in a REIT, the Israeli investor can transform real estate income into dividend income, and in the process, absent the special rule, transform, at no tax cost, high-taxed income into lower-taxed income. In the absence of the special rule, if the RElT shareholder is an Israeli corporation that owns at least a 10 percent interest in the REIT, the withholding rate would be 12.5 percent; in all other cases it would be 25 percent. In either event, with one exception, a tax of at least 30 percent would be significantly reduced. The exception is the relatively small individual Israeli investor who might be subject to a U.S. tax of 15 percent of the net income even if he earned the real estate income directly. Under the rule in subparagraph (a), such individuals, defined as those holding less than a 10-percent interest in the REIT, remain taxable at source at a 25-percent portfolio dividends withholding rate.

Subparagraph (b) of paragraph (3) provides analogous rules for dividends paid by certain Israeli corporations. Under that new subparagraph, the reduced rates of tax at source on dividends provided in paragraph (2) do not apply to dividends paid by certain Israeli corporations that are taxed in a ·pass-through" manner. The income of these corporations is taxed in the manner described in Sections 64 and 64A of the Israeli Income Tax Ordinance. Paragraph 9 of the Exchange of Notes explains that there are several types of “pass-through”corporations that meet the standard of subparagraph (b). The corporation may be exempt from tax; the shareholders may be subject to tax on their pro-rata shares of the corporation's income; or the corporation say deduct its dividends paid from its taxable income. In cases covered by this subparagraph, the income is treated as if it were business profits from a permanent establishment, taxable according to the rules of Article 8 (Business Profits).