Article 11 specifies the taxing — U.S. Income Tax Treaty

and residence and defines the terms necessary to apply the article.

Paragraph 1

The right of a beneficial owner’s country of residence to tax interest arising in the source country is preserved by paragraph 1, which permits a Contracting State to tax its residents on interest paid to them by a resident of the other Contracting State. For interest from any other source paid to a resident, Article 22 (Other Income) grants the residence country exclusive taxing jurisdiction (other than for interest attributable to a permanent establishment or fixed base in the other State).

Paragraph 2

Paragraph 2 grants to the source State the right to tax interest payments beneficially owned by a resident of the other State. The general rate of source country tax applicable to interest payments under paragraph 2 is limited to 10 percent. Under the provisions of paragraph 3, the rate is modified and certain classes of interest payments are exempt from source country tax.

The benefits of paragraphs 2 and 3 may be granted at the time of payment by means of reduced withholding at source. It also is consistent with the paragraphs for tax to be withheld at the time of payment at full statutory rates, and the treaty benefit to be granted by means of a subsequent refund so long as such procedures are applied in a reasonable manner. See Article 5 of the Protocol, discussed below, regarding Italy’s existing practice for implementing these benefits.

The term "beneficial owner" is not defined in the Convention, and is, therefore, defined as under the internal law of the country imposing tax (i.e., the source country). The beneficial owner of the interest for purposes of Article 11 is the person to which the interest income is

attributable for tax purposes under the laws of the source State. Thus, if interest arising in a Contracting State is received by a nominee or agent that is a resident of the other State on behalf of a person that is not a resident of that other State, the interest is not entitled to the benefits of this Article. However, interest received by a nominee on behalf of a resident of that other State would be entitled to benefits. These limitations are confirmed by paragraph 8 of the OECD Commentaries to Article 11. See also paragraph 24 of the OECD Commentaries to Article 1 (Personal Scope).

Paragraph 11 of Article 1 of the Protocol provides an anti-abuse exception to the limitations on source-country taxation of interest in paragraphs 1, 2, and 3 of Article 11. This exception is consistent with the policy of Code sections 860E(e) and 860G(b) that excess inclusions with respect to a real estate mortgage investment conduit (REMIC) should bear full U.S. tax in all cases. Without a full tax at source foreign purchasers of residual interests would have a competitive advantage over U.S. purchasers at the time these interests are initially offered. Also, absent this rule the U.S. FISC would suffer a revenue loss with respect to mortgages held in a REMIC because of opportunities for tax avoidance created by differences in the timing of taxable and economic income produced by these interests.

Paragraph 3

Paragraph 3 specifies certain categories of interest that are exempt from source State taxation. Subparagraph 3(a) exempts interest arising in one Contracting State that is beneficially owned by a resident of the other Contracting State that is a qualified governmental entity that holds, directly or indirectly, less than 25 percent of the capital of the person paying the interest. Subparagraph 3(b) exempts interest arising in a Contracting State if it is paid with respect to debt obligations guaranteed or insured by a qualified governmental entity of either Contracting State and is beneficially owned by a resident of the other Contracting State. A qualified governmental entity is defined in paragraph 1(i) of Article 3 (General Definitions). The definition does not include a governmental entity that carries on commercial activity.

Subparagraph 3(c) exempts from source State taxation interest paid or accrued with respect to credit between enterprises for the sale of goods, merchandise, or services. Subparagraph 3(d) exempts from source State taxation interest paid or accrued in connection with the sale on credit of industrial, commercial, or scientific equipment. Unlike the exemption in subparagraph 3(c), the exemption in subparagraph 3(d) does not require that the sale be between enterprises.

Paragraph 4

Paragraph 4 defines the term “interest” as used in Article 11. The term "interest" includes, inter alia, income from debt claims of every kind, whether or not secured by a mortgage. Interest that is paid or accrued subject to a contingency is within the ambit of Article 11. This includes income from a debt obligation carrying the right to participate in profits. The term does not, however, include amounts that are treated as dividends under Article 10 (Dividends) or penalty charges for late payment.

The term interest also includes amounts subject to the same tax treatment as income from money lent under the law of the State in which the income arises. Thus, for purposes of the Convention amounts that the United States will treat as interest include

(i) the difference between the issue price and the stated redemption price at maturity of a debt instrument, i.e., original issue discount (OID), which may be wholly or partially realized on the disposition of a debt instrument (section 1273),

(ii) amounts that are imputed interest on a deferred sales contract (section 483), (iii) amounts treated as interest or OID under the stripped bond rules (section 1286),

(iv) amounts treated as original issue discount under the below-market interest rate rules (section 7872),

(v) a partner's distributive share of a partnership's interest income (section 702), (vi) the interest portion of periodic payments made under a "finance lease" or similar contractual arrangement that in substance is a borrowing by the nominal lessee to finance the acquisition of property,

(vii) amounts included in the income of a holder of a residual interest in a REMIC (section 860E), because these amounts generally are subject to the same taxation treatment as interest under U.S. tax law, and

(viii) embedded interest with respect to notional principal contracts.

Paragraph 5

Paragraph 5 provides an exception to the limitations on source State taxation of paragraphs 1, 2, and 3 in cases where the beneficial owner of the interest carries on business through a permanent establishment in the State of source or performs independent personal services from a fixed base situated in that State and the debt-claim in respect of which the interest is paid is effectively connected with that permanent establishment or fixed base. In such cases the State of source will retain the right to impose tax on such interest income. Paragraph 10 of Article 1 of the Protocol clarifies that the provisions of Article 7 (Business Profits) or Article 14 (Independent Personal Services), as the case may be, apply to such interest.

In the case of a permanent establishment or fixed base that once existed in the State but that no longer exists, the provisions of paragraph 5 also apply, by virtue of paragraph 6 of Article 7 (Business Profits), to interest that would be attributable to such a permanent establishment or fixed base if it did exist in the year of payment or accrual. See the Technical Explanation of paragraph 6 of Article 7.

Paragraph 6

Paragraph 6 provides rules for sourcing interest. Generally, interest is deemed to arise in a Contracting State when the payer is a resident of that State. When the payer of the interest has a permanent establishment or fixed base in a Contracting State in connection with which the indebtedness on which the interest is paid was incurred, and the interest is borne by the permanent establishment or fixed base, then the interest is deemed to arise in the State where the

permanent establishment or fixed base is located. This rule applies whether or not the person paying the interest is a resident of a Contracting State. Thus, for example, if an enterprise of a third state had a permanent establishment in the United States, the United States could impose tax on interest paid by the permanent establishment to a resident of Italy, but only at the rates provided by paragraph 2 and 3.

Paragraph 7

Paragraph 7 provides that in cases involving special relationships between persons, Article 11 applies only to that portion of the total interest payments that would have been made absent such special relationships (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 Italy, respectively, with due regard to the other provisions of the Convention. Thus, if the excess amount would be treated under the source country's law as a distribution of profits by a corporation, such amount could be taxed as a dividend rather than as interest, but the tax would be subject, if appropriate, to the rate limitations of paragraph 2 of Article 10 (Dividends).

The term "special relationship" is not defined in the Convention. In applying this paragraph the United States considers the term to include the relationships described in Article 9, which in turn correspond to the definition of "control" for purposes of section 482 of the Code.

This paragraph does not address cases where, owing to a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the interest is less than an arm’s length amount. In those cases a transaction may be characterized to reflect its substance and interest may be imputed consistent with the definition of interest in paragraph 4. Consistent with Article 9 (Associated Enterprises), the United States would apply section 482 or 7872 of the Code to determine the amount of imputed interest in those cases.

Paragraph 8

Paragraph 8 permits the United States to impose its branch level interest tax on a corporation resident in Italy. The base of this tax is the excess, if any, of the interest deductible in the United States in computing the profits of the corporation that are subject to tax in the United States and either attributable to a permanent establishment in the United States or subject to tax in the United States under Article 6 or Article 13 of this Convention over the interest paid by or from the permanent establishment or trade or business in the United States.

Paragraph 9

Paragraph 9 provides that the benefits of this Article will be denied in cases in which the main purpose, or one of the main purposes, for the creation or assignment of the debt-claim in respect of which the interest is paid is to take advantage of this Article. This provision is analogous to paragraph 10 of Article 10 (Dividends), discussed above.

Relation to Other Articles

Notwithstanding the foregoing limitations on source country taxation of interest, the saving clause of paragraph 2 of Article 1 permits the United States to tax its residents and citizens, subject to the special foreign tax credit rules of paragraph 4 of Article 23 (Relief from Double Taxation), as if the Convention had not come into force.

As with other benefits of the Convention, the benefits of Article 11 are available to a resident of the other State only if that resident is entitled to those benefits under the provisions of Article 2 of the Protocol, regarding limitation on benefits.