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

Convention. Paragraph (1) of Article XIII replaces paragraph (2) of Article 26. Due to changes in law, paragraph (2) of the Convention dealing with payments made or received on a compulsory loan to Israel is no longer relevant. The new paragraph (2) provides special rules for the tax treatment in both Contracting States of certain types of income derived from U.S. sources by U.S. citizens who are resident in Israel. Since U.S. citizens are subject to United States tax at graduated rates on their worldwide income, the U.S. tax on the U.S. source income of a U.S. citizen resident in Israel will often exceed the U.S. tax allowable under the Convention on an item of U.S. source income derived by a resident of Israel who is not a U.S. citizen. Without this provision U.S. citizens resident in Israel would potentially be subject to double taxation with respect to this income.

Subparagraph (a) of paragraph (2) provides a special Israeli credit rule with respect to items of income that are either exempt from U.S. tax or subject to reduced rates of U.S. tax under the provisions of the Convention when received by Israeli residents who are not U.S. citizens. The Israeli foreign tax credit allowed by subparagraph (a) under these circumstances, to the extent consistent with Israeli law, need not exceed the U.S. tax that may be imposed under the provisions of the Convention, other than tax imposed solely by reason of the U.S. citizenship of the taxpayer under the provisions of the saving clause of paragraph (3) of Article E (General Rules of Taxation). Thus, if a U.S. citizen resident in Israel receives U.S. source dividends, the Israeli foreign tax credit would be limited to 25 percent of the dividend-- the U.S. tax that may be imposed under subparagraph (a) paragraph (2) of Article 12 (Dividends) -- even if the shareholder is subject to a U.S. rate of tax of 31 percent (or more) because of his U.S. citizenship.

Subparagraph (b) of paragraph (2) deals with the potential for double taxation that can arise as a result of the absence of a full Israeli foreign tax credit for the U.S. tax imposed on its citizens resident in Israel. The subparagraph provides that the United States will credit the Israeli income tax paid, after the Israeli credit provided for in subparagraph (a). It further provides that in allowing the credit, the United States will not reduce its tax below the amount that is allowed as a creditable tax in Israel under subparagraph (a) (i.e., the amount that the United States may impose on an Israeli resident under the convention). Since the income that is dealt with in this paragraph is U.S. source income, special rules are required to resource some of the income as Israeli source in order for the United States to be able to credit the Israeli tax. This resourcing rule is provided for in subparagraph (c), which deems the items of income referred to in subparagraph (a) of paragraph (2) to be from Israeli sources to the extent, but only to the extent, necessary to avoid double taxation under subparagraph (b). Thus, no excess credits can be generated in applying this rule that can be used against U.S. tax on any other item of income.

Paragraph 2 of Article XIII of the Protocol makes a clarifying amendment to the Israeli foreign tax credit rule in paragraph (3) of Article 26. As amended, the paragraph makes clear that the Israeli foreign tax credit is applied in a manner consistent with the provisions end limitations of Israeli law concerning the provision of a foreign tax credit, as the law is in force at the time the provision is being applied. However, the law as it is applied at any time must be consistent with the general provisions of the paragraph, i.e., it must continue to provide for a full foreign tax credit for U.S. income tax.

Paragraph 3 of Article XIII of the Protocol adds a new paragraph (4) to Article 26 of the Convention. Paragraph (4) specifies how the source rules in Article 4 (Source of Income) are to apply for purposes of computing the foreign tax credit under Article 26. It provides, first, that the source rule for the taxation of gain on tangible or intangible assets in paragraph (6) of Article 4 (Source of Income) applies for the purpose of computing the foreign tax credit under Article 26. It is intended that this rule apply notwithstanding the saving clause of paragraph (3) of Article 6. Thus, where subparagraph (a) of paragraph (1) of Article 15 (Capital Gains) gives one Contracting State the right to tax the gain of a resident of the other on the alienation of shares in a corporation of the first-mentioned State, the gain will be sourced, for credit purposes, in that first-mentioned State. Paragraph (4) provides further that the other source rules in Article 4 also will apply for foreign tax credit purposes, to the extent not prohibited by the domestic law of the

contracting State that is providing the credit. Thus, in computing the U.S. foreign tax credit section 904(g) of the Code, which provides for particular source rules for foreign tax credit purposes, will apply. Moreover, other source rules in Article 4 also would yield to conflicting source rules of domestic law without regard to their date of enactment.