ARTICLE 13

Interest

The 1954 Convention provided that interest derived from sources within one State by a resident of the other State not having a permanent establishment in the former State would be subject to tax in the former State at a rate not in excess of 10 percent.

The new Convention retains the 10-percent rate on interest. The Convention also provides that interest derived from sources within the United States will be exempt from United States tax if such interest is derived by the Bank of Japan or by the Export- Import Bank of Japan, or by any resident of Japan either with respect to debt obligations guaranteed or indirectly financed by either of such Japanese banks or with respect to debt obligations insured by Japan pursuant to Law No.67, March 31, 1950, concerning Export Insurance. In an exchange of notes the Contracting States stated an understanding that a debt obligation would be treated as indirectly financed by the Export-Import Bank of Japan in cases where that Bank provides funds in the form of export credit, import credit, or investment credit to a resident of Japan for the purpose of permitting the resident of Japan to extend credit to a resident of the United States and the debt obligation represents such extension of credit to the resident of the United States.

A reciprocal exemption is also provided in the case of interest derived from sources within Japan by any Federal Reserve Bank in the United States or by the Export-Import Bank of the United States, or by any resident of the United States with respect to debt obligations guaranteed, insured, or indirectly financed by any of such United States banks.

The 1954 Convention provided similar reciprocal exemptions, but the exemptions were limited to interest derived by the central banks and the Export-Import Banks of the Contracting States.

As noted above in connection with Article 12 (relating to dividends), the Convention abandons the "force of attraction" principle, replacing it with the effectively connected approach. Thus, the reduced rates of tax and the exemptions applicable to interest apply unless the recipient

has a permanent establishment in the State of source and the indebtedness giving rise to the interest is effectively connected with such permanent establishment. In such a case, the interest may be taxed as industrial or commercial profits.

Interest is defined generally as income from any kind of debt-claim or any income treated as interest under the tax law of the State of source. If excessive interest is paid by a payor who is related to the recipient, the provisions of this article apply only to so much of the interest as would have been paid to an unrelated person. Excess interest payments may be taxed by each State according to its own law including the provisions of the Convention where applicable.

The source of interest income is determined under paragraph (2) of Article 6 (relating to the source of income)

As in the case of dividends, the Convention does not contain the provision found in many of our recent conventions exempting from tax by one of the States interest paid by a resident of the other State to a resident of a third State. Under Japanese tax law, interest paid by a United States resident to a resident of a third State would not be subject to Japanese tax, but under sections 861(a)(1)(C) and (D) and 1442 of the Internal Revenue Code, interest paid by a Japanese corporation to a resident of a third State could be subject to United States tax in exceptional circumstances. This could happen only where 50 percent or more of the Japanese corporation's gross income is effectively connected with the conduct of a U.S. trade or business over a specified 3-year period.