Article XII of the Protocol — U.S. Income Tax Treaty

Convention with a new Article 25 (Limitation on Benefits). Article 25 ensures that source-basis tax benefits granted by a Contracting State pursuant to the Convention are limited to the intended beneficiaries -- residents of the other Contracting State that have a substantial nexus with that State. For example, a resident of a third State might establish an entity resident in a Contracting State for the purpose of deriving income from the other Contracting State and claiming sourceState benefits with respect to that income. Absent Article 25, the entity would generally be entitled to benefits as a resident of a Contracting State, subject, to any limitations imposed by the domestic law of the source State, (e.g., business purpose, substance-over-form, step transaction or conduit principles)

Paragraph 1 describes two conditions either of which if satisfied will disqualify a person from claiming benefits under the Convention, unless the person qualifies for benefits under either paragraphs (3) or (4). Paragraph (2) contains a special rule aimed at companies that issue "alphabet" stock to third country residents in order to allow them to effectively claim benefits under the Convention. Although the structure of this Article differs from the limitation on benefits articles of other recent treaties (e.g., the Convention Between the Federal Republic of Germany and the United States of America) it achieves the same result.

Under paragraph (l), benefits will be denied to a resident of a Contracting State, such as a corporation, partnership or trust, if either

(i) 50 percent or more of the beneficial interests in the person (or, in the case of a corporation, 50 percent or more of the voting power or value or its shares) is owned, directly or indirectly, by individuals who are not residents of a Contracting State, and who are not citizens of a Contracting State who are subject to tax in that State on worldwide income, or

(ii) 50 percent or more of the person's gross income is used in substantial part, directly or indirectly, to meet liabilities in the form of deductible payments (including liabilities for interest or royalties) to persons who are residents of a state other than a Contracting State, and who are not citizens of a Contracting State who are subject to tax in that State on worldwide income.

The rationale for disqualifying a resident of a Contracting State in these two cases is that treaty benefits can be indirectly enjoyed not only by equity holders of an entity, but also by that entity's various classes of obligees, such as lenders, licensors, service providers, insurers and

reinsurers, and others. Accordingly, it is not enough, in order to prevent such benefits from inuring substantially to third-country residents, merely to require substantial ownership of the entity by treaty country residents. It also is necessary to require that the entity's deductible payments be made in substantial part to such treaty country residents or their equivalents.

Paragraph (2) address the potential for abuse when a company (or another company that controls that company) issues a class of shares that entitles its holders to a disproportionately high share of income derived in the other Contracting State, either from activities performed or assets located in that State. If 50 percent or more of the shares of this class is owned, directly or indirectly, by persons that would disqualify the corporation for benefits under subparagraph (a) of paragraph (1), then the Convention's benefits with respect income attributable to those assets or activities will be denied by paragraph (2). For example, a U.S. holding company could issue a class of shares (class B shares) entitling the class B shareholders to the dividends received from an Israeli subsidiary operating in Israel. If more than 50 percent of the vote and value of all of the U.S. company's shares is held by U.S. residents the holding company would not be denied benefits under paragraph (1). However, if a majority of the class B shares were held by thirdcountry residents, paragraph (2) would deny the benefits of the Convention (reduced Israeli tax at source) with respect to the Israeli subsidiary's dividends. Were this not the rule and assuming there were a treaty in effect between the United States and the third country to reduce the U.S. dividend withholding tax, this structure would provide opportunities for third country residents to effectively claim the benefits of the Convention on dividends paid by the Israeli corporation.

Paragraph (3) identifies a number of classes of persons resident in one Contracting State that are entitled to treaty benefits from the other, either in full or with respect to particular items of income, notwithstanding paragraphs (1) and (2). First, under subparagraph (a), individuals who are residents of a Contracting State are, without qualification, entitled to benefits under the Convention. Second, subparagraph (b) provides that

(i) a Contracting State or a political subdivision or local authority thereof, (ii) a corporation that is wholly owned by a Contracting. State or a political subdivision or local authority thereof, provided the corporation performs functions of a Governmental nature, and

(iii) a body that is treated for tax purposes the same as a Contracting State or a political subdivision or local authority thereof and that performs functions of a Governmental nature, are entitled to benefits under the Convention.

Subparagraph (c) of paragraph (3) provides a test for eligibility for benefits that looks not solely at objective characteristics of the person deriving the income, but at the nature of the activity carried on by that person and the connection between the income and that activity. Under subparagraph (c) a resident of a Contracting State deriving income from the other Contracting State is entitled to benefits if the recipient is engaged in an active trade or business in its State of residence, and the item of income in question is derived in connection with, or is incidental to, that trade or business. For this purpose an active trade or business does not include the business of making or managing investments, unless these activities are banking or insurance activities carried on by a bank or insurance company. This relationship test is applied separately for each item of income, and it is intended that the provisions of this paragraph are self-executing. The tax

authorities say, of course, on review, determine that the taxpayer ham improperly interpreted the subparagraph and is not entitled to the benefits claimed.

The first six examples in the Memorandum of Understanding Regarding the Scope of the Limitations on Benefits Article in the Convention Between the Federal Republic of Germany and the United States of America illustrate the Situations intended to be covered by this provision. For example, income is considered "derived in connection with" an active trade or business when the income is a dividend paid to a United States manufacturing company by its sales subsidiary in Israel that is selling in Israel the output of the U.S. parent. Income would be considered "incidental to" an active trade or business if, for example, the income were dividends earned by an Israeli corporation from investing some of its working capital, temporarily, in U.S. preferred shares. Even if the Israeli company has no other activities in the United States, the dividends from those shares would be considered incidental to the active business of the company in Israel, and would be entitled to U.S. treaty benefits.

Under subparagraph (d) of paragraph (3), a corporation that is a resident of a Contracting State is entitled to treaty benefits from the other Contracting State if there is substantial and regular trading in the corporation's principal class of shares on a recognized stock exchange. The term "recognized stock exchange" is defined in paragraph (5) of the Article to mean, in the United States, the NASDAQ System and any stock exchange that is registered as a national securities exchange with the Securities and Exchange Commission for purposes of the Securities Exchange Act of 1934. In Israel, the term means the Tel Aviv Stock Exchange, and any other Israeli stock exchange that say be approved by the Israeli Minister of Finance. The competent authorities may, by mutual agreement, recognize additional exchanges for purposes of subparagraph (d).

Subparagraph (e) of paragraph (3) provides that a not-for-profit organization that is a resident of a Contracting State is entitled to benefits from the other Contracting State if it satisfies two conditions:

(i) it generally must be exempt from tax in its State of residence by virtue of its not-for-profit status; and

(ii) more than half of the beneficiaries, members or participants, if any, in the organization must be persons entitled, under this Article, to the benefits of the Convention.

The not-for-profit organizations dealt with in the subparagraph include pension funds, pension trusts, private foundations, trade unions, trade associations and similar organizations. Thus, an Israeli pension fund that provides pension benefits principally to Israeli residents would be entitled to benefits with respect to its U.S. source investment income.

Paragraph (4) provides that a resident of a Contracting State that derives income from the other Contracting State and is not entitled to the benefits of the Convention under other provisions of the Article may, nevertheless, be granted benefits at the discretion of the competent authority of the Contracting State in which the income arises. The paragraph further provides that if a competent authority proposes to deny a request for benefits under this provision, either competent authority may request consultations with the other to discuss the issue.

The paragraph itself provides no guidance to competent authorities or taxpayers as to how the discretionary authority is to be exercised. It is understood, however, that in making determinations under paragraph (4), the competent authorities will take into account all relevant facts and circumstances. The factual criteria that the competent authorities are expected to take into account include the existence of a clear business purpose for the structure and location of the income earning entity in question; the conduct of an active trade or business (as opposed to a mere investment activity) by such entity; and a valid business nexus between that entity and the activity giving rise to the income. Paragraph 13 of the Exchange of Notes, for example, states the understanding that benefits would be likely to be granted by the competent authority in the case of a resident of a Contracting State that did not pass the base-erosion test of paragraph (1) of the Article because of large interest payments on a bona-fide loan from a financial institution resident in a third country. For this purpose a "bona-fide loan" would not include a conduit financing arrangement recharacterized under section 7701(1) of the Code or Rev. Rul. 87-89, 1987-2 C.B. 195.

For purposes of implementing paragraph (4), a taxpayer will be permitted to present his case to his competent authority for an advance determination based on the facts, and will not be required to wait until the tax authorities of one of the Contracting States have determined that benefits are denied under one of the other provisions of the Article. It also is expected that if the competent authority determines that benefits are to be allowed, they will be allowed retroactively to the time of entry into force of the relevant treaty provision or the establishment of the structure in question, whichever is later.

Subparagraph (c) of paragraph (4) provides that the competent authorities are expected to consult with a view to developing agreed procedures for the application of Article 25, including, as provided in paragraph 14 of the Exchange of Notes, the development of a Memorandum of Understanding to provide guidance to both taxpayers and tax administrations. It is further expected that as, over time, the tax authorities of the Contracting States gain experience in administering the provisions of Article 25, further guidance will be developed and published.