Article 11. INTEREST

This Article governs the taxation of interest. The ability of the residence State to tax interest is provided by paragraph 1 and also preserved by the saving clause of paragraph 3 of Article 1 (General Scope). Interest derived from one Contracting State and beneficially owned by a resident of the other State may also be taxed by the first (source) State. However, as provided in paragraph 2, the tax imposed by the source State may not exceed 10 percent. This reduced rate does not apply to back-to-back loans. Notwithstanding its treaty obligation to limit the rate of tax applied to interest, the source State may, in accordance with point 4 of the Protocol, withhold on interest at its domestic rates, as long as it timely refunds any excess amount withheld over the maximum rates established by the treaty.

In the absence of the Convention, Kazkhstan's withholding rate on interest paid to a U.S. resident (and not attributable to a permanent establishment of that resident in Kazakhstan) would

be 15 percent. The general U.S. statutory rate on payments of interest to nonresidents is 30 percent, with an exemption for portfolio interest.

The preferred U.S. treaty policy is source country exemption of interest paid to a resident of the other country. This policy coincides with U.S. internal law, which generally exempts interest paid to nonresidents from U.S. tax. It is not uncommon, however, particularly in treaties with developing countries, for the United States to agree to some source country tax. Point 3 a) of the Protocol provides that, if Kazahkstan agrees in a treaty, between it and another country that is a member of the OECD to impose a rate at source on interest lower than the 10 percent provided for in this Convention, this Convention will be promptly amended to incorporate that lower rate. The amended Convention would then be submitted to the United States Senate for its acceptance of the lower rate (see also, point 4 of the Memorandum of Understanding).

As the term "interest" is not specifically defined in the Convention, its meaning depends upon the domestic law of the State whose t ax is being applied (see paragraph 2 of Article 3 (General Definitions)). The term is used in the Convention in the usual sense to refer to income from debt claims of every kind other than those giving rise to dividends under paragraph 3 of Article 10 (Dividends). Penalties and fines for late payment are generally not included in the treaty concept of interest; such amounts may be imposed in accordance with domestic law.

Paragraph 3 specifies two categories of interest that, notwithstanding the provisions of paragraph 2, are exempt from tax at source when the beneficial owner is a resident of the other State. Those categories are: (i) interest paid or beneficially owned by either Contracting State or any political subdivision or local authority thereof or any government instrumentality agreed upon by the competent authorities, and (ii) interest on loans of three years or longer that are made, guaranteed, or insured by a specified public lending institution. Point 3 b) of the Protocol provides that the lending institutions to which loans in (ii) will apply are the Export-Import Bank, the Overseas Private Investment Corporation of the United States, and any other similar agencies that are agreed upon in the future by the competent authorities. Point 3 b) of the Protocol further provides that there will be no required exemption for loans made or guaranteed by these institutions if the lender has a right of recourse against any person other than the borrower or a governmental body in the borrower's country. This Point arose from Kazakhstan's view that the exemption should not cover internal group financing or loans to joint ventures in which there are other foreign participants besides the U.S. venturers.

Paragraph 4 provides an exception from the rules of paragraphs 1, 2, and 3 in cases where the beneficial owner of the interest, a resident of one Contracting State, carries on business through a permanent establishment in the other Contracting State or performs independent personal services through a fixed based situated in that other State and the interest is attributable to that permanent establishment or fixed base. In such a case, the income is taxable to the permanent establishment or fixed base in accordance with the provisions of Article 6 (Business Profits) or Article 14 (Independent Personal Services). This rule applies even if the permanent establishment or fixed base no longer exists when the interest is received or accrued, as long as the interest would have been attributable to the permanent establishment or fixed base if it had been paid or accrued in the earlier year.

Paragraph 5 provides a source rule. Interest is considered to arise in a Contracting State if paid by a resident of that State (including the State itself). In addition, interest paid by any person (whether or not a resident) and borne by a permanent establishment or fixed base or other activity giving rise to income subject to tax on a net basis in the non-residence State under the Convention (e . g ., income from real property under Article 9, certain royalty income under paragraphs 2 and 3 b) of Article 12, and gains under paragraph 1 or 2 of Article 13) is considered to arise in that State. For this purpose, interest is considered to be "borne by" a permanent establishment, fixed base, or other trade or business if it is allocable to (whether or not deductible from) taxable income of that permanent establishment, fixed base, or trade or business. If the actual amount of interest on the books of a U.S. branch of a Kazakh business exceeds the amount of interest allocated to the branch under Treas. Reg. § 1.882-5, any such interest will not be considered U.S. source interest for purposes of this Article. Conversely, the total amount of interest allocated to the branch under that regulation will be U.S. source even if the amount exceeds branch book interest.

The source rules in paragraph 5, as applied to interest paid by Kazakh corporations conducting business in the United States through a permanent establishment or fixed base, are consistent with the rules contained in Treas. Reg. § 1.884-4, which treat interest allocable to the U.S. trade or business of a foreign corporation under Treas. Reg. § 1.882-5 as if such interest were paid by a domestic corporation and, thus, sourced in the United States. The presence of this source rule confirms that interest paid by a U.S. permanent establishment of a Kazakh corporation, within the meaning of section 884(f)(1)(A) of the Code, is subject to a 10 percent rate of tax pursuant to paragraph 2 where such interest is paid to a resident of Kazakhstan.

Paragraph 6 provides that if, as a result of a special relationship between persons, the amount of interest paid is excessive, Article 11 will apply only to the amount of interest payments that would have been made absent such special relationship ( i.e.. an arm's length interest payment). Any excess amount of interest paid remains taxable according to the domestic law of the source State, with due regard to the other provisions of the Convention. Thus, for example, if the excess amount would be treated as a distribution of profits, 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).

Point 3 c) of the Protocol reserves the right of the United States to tax an excess inclusion of a residual holder of a Real Estate Mortgage Investment Conduit (REMIC) in accordance with U.S. domestic law; thus, the tax on such an excess inclusion of a resident of Kazakhstan would be subject to the domestic rate of withholding tax, now 30 percent.

Paragraph 7 clarifies that the United States may also impose a tax on the "excess interest amount" of a Kazakh resident that conducts business in the United States through a permanent establishment or fixed base or derives income in the United States that is otherwise subject to tax on a net basis under the Convention. Paragraph 7 limits the rate of such tax, however, to not more than 10 percent of the "excess interest amount." This is the same rate that applies to interest under paragraph 2.

The "excess interest amount" is defined in point 3 d) of the Protocol to coincide with the provisions of Code section 884(f)(1)(B). Accordingly, the United States may apply its tax on excess interest (but at the lowered treaty rate) to the excess, if any, of (i) interest borne by a U.S. permanent establishment, fixed base, or other trade or business of a Kazakhstan resident subject to tax on a net basis over (ii) the interest paid by such permanent establishment, fixed base, or trade or business. (The interest would be U.S. source under paragraph 5 because it is borne by a U.S. branch.) Under current U.S. law, the excess amount is deemed paid by a U.S. corporation to a Kazakhstan corporation. Moreover, current U.S. law imposes branch level interest taxes only on foreign corporations and not on non-corporate foreign residents. Interest will be considered "borne by" a permanent establishment even if the interest is not fully deductible in that year, provided it is allocable in that year to the permanent establishment's U.S. income under U.S. domestic rules.

Unlike the United States, Kazakhstan does not currently impose a tax on excess interest comparable to the U.S. tax on excess interest. The provisions permitting application of a tax on an excess interest amount, however, are drafted reciprocally.

Should Kazakhstan enact a tax on excess interest, the "excess interest amount" to which it could apply that tax would be limited to the amount of interest deductible in computing the profits of a Kazakh branch of a U.S. resident, provided the amount were similar to the amount that would be "excess interest" under U.S. law.