Article 11 provides rules — U.S. Income Tax Treaty

paid to a beneficial owner that is a resident of the other Contracting State.

Paragraph 1

Paragraph 1 generally grants to the Contracting State of residence the non-exclusive right to tax interest which arises in the other Contracting State and paid to its residents.

Paragraph 2

Paragraph 2 provides that the Contracting State in which the interest arises may also tax the interest, but if the beneficial owner of the interest is a resident of the other Contracting State, the rate of tax shall not exceed 10 percent of the gross amount of the interest.

The term “beneficial owner” is not defined in the Convention, and is, therefore, defined under the internal law of the Contracting State of source. 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 Contracting State of source. Thus, if interest arising in a Contracting State is received by a nominee or agent that is a resident of the other Contracting State on behalf of a person that is not a resident of that other Contracting State, the interest is not entitled to the benefits of Article 11. 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 Commentary to Article 11. See also paragraph 24 of the OECD Commentary to Article 1.

Paragraph 3

Paragraph 3 provides for exclusive residence based taxation ( i.e ., an elimination of source-country withholding tax) in certain cases.

Under subparagraph (a), interest beneficially owned by a Contracting State, a political subdivision or a local authority thereof (i.e., in the United States a State or local government), the central bank of that Contracting State or any institution wholly owned by that Contracting State is subject to exclusive residence based taxation. Paragraph 4 provides a list of institutions in the case of Japan and the United States described by the terms “the central bank” and “institution wholly owned by a Contracting State.” In the case of Japan, these terms include the Bank of Japan, the Japan Bank for International Cooperation, and the Nippon Export and Investment Insurance. In the case of the United States, these terms include the Federal Reserve Banks, the U.S. Export-Import Bank, and the Overseas Private Investment Corporation. Paragraph 4 also provides that this list can be expanded to other financial institutions wholly owned by a Contracting State by agreement between the Governments of the Contracting States through an exchange of diplomatic notes.

Subparagraph (b) provides for exclusive residence based taxation for interest beneficially owned by a resident of a Contracting State with respect to debt-claims backed by that Contracting State or other governmental institutions referred to in subparagraph (a). Interest beneficially owned by a resident of a Contracting State with respect to debt-claims guaranteed, insured or indirectly financed by the Contracting State, a political subdivision or a local authority thereof, the central bank of that Contracting State or any institution wholly owned by that Contracting State (as defined in paragraph 4) is subject to exclusive residence based taxation.

Subparagraph (c) provides that interest beneficially owned by certain financial institutions resident in a Contracting State is subject to exclusive residence based taxation. In particular, exclusive residence based taxation is provided for interest beneficially owned by a

bank, including an investment bank, an insurance company, or a registered securities dealer. Exclusive residence based taxation also is provided for interest beneficially owned by any other enterprise, provided that in the three taxable years preceding the taxable year in which the interest is paid, the enterprise derives more than 50 percent of its liabilities from the issuance of bonds in the financial markets or from taking deposits at interest, and more than 50 percent of the assets of the enterprise consists of debt-claims against persons that are not related to the resident under the standard provided in subparagraph (a) or (b) of paragraph 1 of Article 9 (Associated Enterprises). Thus, non-bank financial institutions such as commercial finance companies or consumer credit companies are covered by this exemption provided that they obtain more than half of their borrowed funds by borrowing from the public.

Paragraph 5 of the Notes provides that the term “bonds” includes bonds, commercial paper, and medium-term notes, whether collateralized or not, and provides that bonds that are subject to transfer restrictions applicable to private placements generally shall not be considered to have been issued in the financial markets. However, offerings qualifying for exemption from securities registration requirements pursuant to Rule 144A promulgated under the Securities Act of 1933 shall not be considered subject to transfer restrictions applicable to private placements, and thus generally shall be considered to have been issued in the financial markets.

It is understood that the asset test and the liability test may be applied on the basis of the average of the assets and liabilities, respectively, of the enterprise at the end of each of the three years preceding the taxable year in which the interest is paid. Thus, for example, if an enterprise derives from the issuance of bonds in the financial markets 30 percent of its liabilities in year 1, 60 percent of its liabilities in year 2, and 70 percent of its liabilities in year 3, then it will be treated as deriving more than 50 percent of its liabilities from the issuance of bonds in the financial markets in the three taxable years preceding year 4.

Subparagraph (d) provides for exclusive taxation by the Contracting State of residence for interest beneficially owned by a pension fund, as defined in subparagraph 1(m) of Article 3 (General Definitions), provided that such dividends are not derived from the carrying on of a business, directly or indirectly, by the pension fund.

Subparagraph (e) provides that interest beneficially owned by a resident of a Contracting State and paid with respect to indebtedness arising as a part of a sale by that resident of equipment or merchandise is subject to exclusive residence based taxation.

Paragraph 4

Paragraph 4 provides a list of institutions described by the terms “the central bank” and “institution wholly owned by a Contracting State”, as used in subparagraphs (a) and (b) of paragraph 3, for purposes of paragraph 3. This list is described in the explanation to paragraph 3, above.

Paragraph 5

The term “interest” as used in Article 11 is defined in paragraph 5 to include, inter alia, income from debt claims of every kind, whether or not secured by a mortgage and whether or not carrying a right to participate in the debtor’s profits. The term does not, however, include amounts that are treated as dividends under Article 10 (Dividends).

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) interest with respect to notional principal contracts that are recharacterized as loans because of a “substantial non-periodic payment.”

Paragraph 6

Paragraph 6 provides an exception to paragraphs 1, 2, and 3 where the beneficial owner of the interest carries on business through a permanent establishment in the Contracting State in which the interest arises and the interest is attributable to that permanent establishment. In such cases, the applicable provisions of Article 7 (Business Profits) will apply.

The provisions of paragraph 4 of the Protocol apply to income described in this paragraph. For example, interest income that is attributable to a permanent establishment and that accrues during the existence of the permanent establishment, but is received after the permanent establishment no longer exists, remains taxable under the provisions of Article 7 (Business Profits), and not under this Article.

Paragraph 7

Paragraph 7 provides a source rule that is similar to the interest source rule of the prior Convention. Interest generally is considered to arise in a Contracting State when paid by a resident of that Contracting State. Special rules are provided where the interest is borne by a permanent establishment of the person paying the interest. In such a case, if the permanent establishment is situated in a Contracting State, then the interest shall be deemed to arise in that Contracting State; and if the permanent establishment is situated in a state other than the Contracting States, then the interest shall not be deemed to arise in either Contracting State. While interest borne by a permanent establishment that is situated in a state other than the

Contracting States thus will not be eligible for the benefits of the Convention, it may be eligible for the benefits of the tax treaty, if any, between the state in which the permanent establishment is situated and the Contracting State of which the beneficial owner of the interest is a resident.

For purposes of paragraph 7, interest is considered to be borne by a permanent establishment if it is allocable to taxable income of that permanent establishment or fixed base. If the actual amount of interest on the books of a U.S. branch of a resident of Japan exceeds the amount of interest allocated to the branch under Treas. Reg. Section 1.882-5, the amount of such excess will not be considered U.S. source interest for purposes of this Article.

Paragraph 8

Paragraph 8 provides that, in cases involving special relationships between persons, Article 11 applies only to that portion of the total interest payments between those persons that would have been made absent such special relationships ( i.e., an arm's-length interest payment). 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 (Associated Enterprises), which in turn correspond to the definition of “control” for purposes of section 482 of the Code. This is consistent with paragraph 33 of the Commentary to Article 11 of the OECD Model.

Paragraph 8 also provides that any amount of interest paid in excess of the amount that would be been paid absent a special relationship may be taxable in the Contracting State in which it arises at a rate not to exceed 5 percent. This rule is similar to rules provided in paragraph 4 of Article 12 (Royalties), and paragraph 3 of Article 21 (Other Income), which provide that any amount paid in excess of the amount that would have been paid absent a special relationship may be taxable in the Contracting State in which they arise at a rate not to exceed 5 percent.

The Convention’s treatment of such excess amounts is consistent in most circumstances with the results under the U.S. Model and U.S. domestic law and practice. Absent the specific rule in the Convention, in most cases the United States would treat such excess amounts as a dividend or as a contribution to capital, depending on the relationship between the parties, and tax such amounts accordingly. Under the Convention, a maximum 5 percent withholding tax rate generally applies to dividends where the beneficial owner is a company owning directly or indirectly at least 10 percent of the voting stock of the company paying the dividends. In Japan, the general practice in the context of investment income such as interest, dividends, or other income is to impose withholding taxes on the amount in excess of the arm’s length amount at the domestic rate. Thus, for example, if a Japanese company makes an interest payment to its nonJapanese parent company, and Japan determines that the amount of the interest payment exceeded an arm’s-length amount, Japan will deny a deduction for the excess amount and treat the excess amount as an interest payment subject to the appropriate withholding rate applicable to interest paid by Japanese companies under its domestic law, which is generally 20 percent. Under the Convention, such excess amounts instead are subject to a maximum 5 percent rate of withholding taxes.

Paragraph 8 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 5. 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 9

Paragraph 9 provides an anti-abuse exception to paragraphs 2 and 3 for excess inclusions from entities used to securitize real estate mortgages or other assets. Sub-paragraph (b) serves as a backstop to Code section 860G(b). That section generally requires that a foreign person holding a residual interest in a real estate mortgage investment conduit (“REMIC”) take into account for U.S. tax purposes “any excess inclusion” and “amounts includible…[under the REMIC provisions] when paid or distributed (or when the interest is disposed of)….”

Without a full tax at source, non-U.S. transferees of residual interests would have a competitive advantage over U.S. transferees at the time these interests are initially offered. Absent this rule, there would be a potential for inappropriate results 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 such interests. In many cases, the transfer to the foreign person is simply disregarded under Reg. § 1.860G-3. Paragraph 9 also serves to indicate that excess inclusions from REMICs are not considered “other income” subject to Article 21 (Other Income).

Paragraph 9 is analogous to subparagraph 5(b) of the U.S. Model, except that in the Convention the provision is drafted to apply bilaterally. Thus, for example, paragraph 9 does not refer to the long-term Federal rate used to determine the amount of an excess inclusion, but rather to “the return on comparable debt instruments as specified by the domestic law of that Contracting State.” Nevertheless, for U.S. tax purposes, the tax imposed “to the extent that the amount of interest paid exceeds the return on comparable debt instruments as specified by the domestic law of that Contracting State” is the withholding tax that would be imposed upon an excess inclusion with respect to a residual interest in a REMIC under section 860G(b).

Unlike the U.S. model, the Convention does not contain a specific provision applicable to so-called “contingent interest.” Under the U.S. Model, which generally exempts interest from source-based taxation (i.e., provides for a zero rate of withholding tax on interest), certain contingent interest that is paid by a resident of one of the Contracting States to a resident of the other Contracting State may be taxed at a rate not exceeding the highest rate applicable to dividend income. This rule is not included in the Convention because the highest rate applicable to dividend income (10 percent, as prescribed in paragraph 2 of Article 10 (Dividends)) is the same as the general rate applicable to interest income (10 percent, as prescribed in paragraph 2 of Article 11 (Interest)).

Paragraph 10

Paragraph 10 permits a Contracting State to impose its branch level interest tax on a corporation resident in the other Contracting State. The base of this tax is the excess, if any, of the interest deductible in the first-mentioned Contracting State in computing the profits of the corporation that are subject to tax in the first-mentioned Contracting State and either attributable to a permanent establishment in the first-mentioned Contracting State or subject to tax in the first-mentioned Contracting State 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 first-mentioned Contracting State. Such excess interest may be taxed as if it were interest arising in the firstmentioned Contracting State and beneficially owned by the corporation resident in the other Contracting State. Thus, such excess interest may be taxed by the Contracting State of source at a rate not to exceed the 10 percent rate provided for in paragraph 2, and shall be exempt from tax by the Contracting State of source if the recipient corporation is described in paragraph 3.

Paragraph 11

Paragraph 11 provides that a resident of a Contracting State shall not be considered the beneficial owner of interest in certain “back-to-back” loan arrangements. The benefits of Article 11 therefore are not available with respect to such interest. This rule is similar to rules dealing with interest, royalties, and other income in paragraph 11 of Article 10 (Dividends), paragraph 5 of Article 12 (Royalties), and paragraph 4 of Article 21 (Other Income). These limited “anticonduit” rules and their interaction with U.S. domestic law are discussed in the explanation of paragraph 11 of Article 10 above.

Paragraph 11 in particular provides that a resident of a Contracting State shall not be considered the beneficial owner of interest in respect of a debt-claim if such debt-claim would not have been established unless a person that is not entitled to the same or more favorable treaty benefits and that is not a resident of either Contracting State held an equivalent debt claim in the resident. The operation of this rule can be illustrated in the following examples:

Example 1. A, a U.S. resident, holds a debt-claim against X, a Japanese company, that entitles A to interest of 10x each year. B, a resident of a third country that does not have a tax treaty with Japan, owns a debt-claim against A that entitles B to interest of 10x each year and otherwise has terms that are equivalent to the terms of the debt-claim held by A. A would not have established its debt-claim against X if B did not hold a debt-claim against A. X pays interest of 10x to A, which pays interest of 10x to B. Under paragraph 11, A will not be considered the beneficial owner of the interest from X, and therefore is not entitled to treaty benefits with respect to the interest from X.

Example 2. The facts are the same as the facts of Example 1, except that, instead of owning a debt-claim against A, B holds preferred stock in A that entitles B to 10x each year to the extent of A’s earnings in that year. A pays dividends of 10x to B. Paragraph 11 does not apply to deny treaty benefits to A with respect to the interest from X.

No inference is intended as to the result of Example 2 in cases of interest arising in the United States under U.S. domestic anti-abuse rules ( e.g., the anti-conduit rules and other antiabuse rules referred to in the explanation of paragraph 11 of Article 10 (Dividends)).

Relation to Other Articles

Notwithstanding the foregoing limitations on source country taxation of interest, the saving clause of subparagraph 4(a) of Article 1 (General Scope) permits the United States to tax its residents and citizens, subject to the special foreign tax credit rules of paragraph 3 of Article 23 (Relief from Double Taxation), as if the Convention had not come into force.

The benefits of this Article are also subject to the provisions of Article 22 (Limitation on Benefits). Thus, if a resident of Japan is the beneficial owner of interest paid by a U.S. corporation, the resident must qualify for treaty benefits under at least one of the tests of Article 22 in order to receive the benefits of this Article.