Article 4. SOURCE OF INCOME

This Article contains the source rules which are to be used in apply­ Ing the provisions of the Convention. For example, under Article 6 (General Rules of Taxation), one Contracting State may tax a resident of the other Contracting State only on income from sources within the

first-mentioned Contracting State (provided such resident is not a citizen of the first-mentioned Contracting State).

Paragraph (l) provides that, as a general rule, dividends will be treated as income from sources within a Contracting State if paid by a corporation of that Contracting State or if paid by a corporation of any State, provided that, in the latter case, at least 50 percent of such cor­ poration's gross income from all sources for the 3-year period (or such part of that period as the corporation has been ln existence) ending with the close of its taxable year preceding the declaration o! the dividends was business profits attributable to a permanent establishment which such corporation had in that Contracting State, In such a case, only a

pro rata portion or the dividend will be treated as income from sou, ces within the applicable Contracting State. Such portion is the amount which bears the same ntio to the dividends as the amount or the business profits attributable to the permanent establishment bears to the corpora­ tion's. gros income, If a dividend would be treated under paragraph (1) as income from sources within both Contracting States, the pro rata portion of the dividend which is deemed to be from sources within the Contracting State in which the permanent establishment Is situated is considered to be from sources only within that Contracting State. The remaining portion of the dividend, if any, shall be considered to be from sources within the other State.

A counterpart to the dividend source rule of the Convention appears in Code section 86l(a)(2)(B). However, under Code section 864(c)(4), only four types of income f'rom sources outside the United States -- certain

rents, royalties, or gains on sales or intangible property: certain dividends or interest, or gains or losses from sales of securities in connection with certain banking, financing and security trading businesses: certain sales of goods or merchandise through an office in the United States; and, certain income received by foreign life insurance companies -- can be considered to be effectively connected with the conduct of a trade or business within the United States, I!, for example, the business profits of a permanent establishment maintained by a Philippine corporation is comprised entirely of income from sources outside the United States not specified in Code section 864(c)(4), the United States wlll not tax a dividend paid by the Philippine corporation even if more than 50 percent of that corporation's gross income is attributable to the permanent estab· lishment. The United States foregoes its right to tax in such circum­ stances. Under paragraph (2) of Artic:le 6 (General Rules of TPxation), the Convention will not increase a person's United States tax.

Under paragraph (2) of Article 4, interest will be treated as income from sources within a Contracting State only if paid by the Contracting State, a political subdivision or local authority thereof', or by a resident of' that Contracting State. The one exception to this rule is that If' interest is paid on an indebtedness incurred in connection with a permanent establishment which bears such interest, then such interest shall be deemed to be from sources within the State (whether or not a Contracting

State) ln which the permanent establ_lshment is situated. This exception permits a Contracting State, under the proper circumstances, to impose a tax on interest borne by a permanent establishment therein, including a permanent establishment of a resident of a State other than a Contract­ ing State. For example, it a resident of France has a permanent es tab• lishment ln the Philippines whic:h borrows money f'rom a resident of' the

United States and bears the interest, the interest will be deemed to be from sources within the Philippines. However, the United States will not, because of Article 6 (General Rules of Taxation) and Code section 861 (a)(l)(C) and (D), impcse a tax on interest received by nonresident alien individuals or foreign corporations from a foreign corporation having a permanent establishment in the United States unless 50 percent

the 3-year period ending with the close of its taxable year preceding the the payment of the interest (or such part of such period as the corpora• or more of the gros lncome of such corpcration from all sources for

of a trade or business within the United States. Even where the United States imposes a tax. no tax will be imposed on the portion of such tion has been ln existence) was effectively coMected with the conduct

interest which bears the same ratio to the total amount of the interest as the gross income of the corporation which was not effectively coMected with the conduct of a trade or business in the United States bears to that corporation's gross income from all sources.

In addition. the permanent establishment exception to the general source rule for interest will exempt interest from tax in the Contracting State in which the payor resides if the payor has a permanent establish­

ment in a State other than a Contracting State in coMection with which the indebtedness of which the interest is paid was incurred. such interest is borne by the permanent establishment and such interest is paid to a resident of the other Contracting State. This results. once again. from the restriction in paragraph (l) of Article 6 (General Rules of Taxation) that a resident of one Contracting State, not a citizen of the other Con• tracting State. may be taxed by the other Contracting State only on income from sources within that other Contracting State. For example. lf a resi­ dent of the United States has a permanent establishment in France which borrows money from a resident of the Philippines and bears the interest. the interest will be deemed to be from French sources. even if paid by the United States resident. Thus. the United States may not tax such income unless the recipient-resident of the Philippines is a citizen of the United States or has a permanent establishment in the U.S. to which the income is attributable. The rules of Article 5 (Permanent Establishment) will be applied to determine whether the resident of the United States has a permanent establishment in France.

Paragraph (3) provides that royalties for the use of. or the right to use. property or rights will be treated as income from sources within a Contracting State only to the extent that such royalties are for the use of. or the right to use. such property or rights within that Contracting State. However. if a royalty is paid with respect to a liability to pay

the royalty that was incurred in coMection with a permanent establishment which bears that royalty. then such royalty shall be deemed to be from sources within the State (whether or not a Contracting State) in which the permanent establishment is situated. It is intended that such exception will be applied in a maMer similar to the exception with respect to interest. However. the United States will not. because of Code sections 861(a)(4) and 862{a)(4). impcse a tax on royalties received by nonresident aliens or foreign corporations from a foreign corporation having a per• manent establishment in the United States except to the extent that the royalties are for the use of. or the privilege of using, the property in the United States or the recipient of the royalties is engaged in the active conduct of a business in the United States so that Code section 864(c)(4 )(B)(i) applies.

Paragraph (4) provides that income (including royalties) to which Article 7 (Income from Real Property) applies wil be treated as income from sources within a Contracting State ohly if the real property is situated in that Contracting State,

. Under paragraph (5), income received by an individual for his per­ formance of labor or personal services, whether as an employee or in an independent capacity, will be treated as income from sources within a Contracting State ohly to the extent that such services are performed in that Contracting State, However, income from personal services performed aboard ships or aircraft operated by a resident of a Contract­ ing State in international traffic wil be treated as income from sources within th.at Contracting State if rendered by a member of the regular complement of that ship or aircraft, Notwithstanding the general rule and the above described exception, remuneration described in Article 20 (Governmental Functions) and payments described in Article 19 (Social Security Payments) paid from the public funds of a Contracting State or

a political subdivision or local authority thereof wil be treated as income from sources within that Contracting State only,

Paragraph (6) contains a general qualification to the preceding source rules, It provides that business profits attributable to a permanent estab­ lishment which the recipient, a resident of one Contracting State, has in the other Contracting State wil be treated as income from sources within that other Contracting State, Business profits attributable to such

permanent establishment may include any item of income described in paragraphs (l) through (4) i! the item of income· is effectively connected with the permanent establishment. See the discussion of paragraph (6) of Article 8 (Business Profits) for a discussion of the "effectively con­ nected" concept.

Under paragraph (7), gross revenues from the operation of ships or aircraft in international traffic wil be treated as from sources within a Contracting State to the extent the revenues are derived from outgoing traffic originating in that State. Thus, !or example, gross revenues derived from transporting passengers and freight from Manila to Hawaii, non-stop aboard an airplane, are deemed to be derived from sources within the Philippines for purposes of the Convention,

Under paragraph (8), the source of any item of income not described in the preceding paragraphs of Article 4 wil be determined by each Con­ tracting State in accordance with its own law, However, if the source of any such item of income under the laws of one Contracting State is different from its source under the laws of the other Contracting State or if its source is not readily determinable under the laws of one of the

Contracting States, the competent authorities of the Contracting States may, in order to prevent double taxation or further any other purpose of the Convention, establish a common source of the item of income for purposes of the Convention,

As mentioned previously, several ot the source rules set out in this Article dif er to some degree from those provided in the Code. Since paragraph (2) of Article 6 (General Rules of Taxation) provides that the Convention will not increase a person's United States tax, a taxpayer is entitled to use the more beneficial or the Code rules or the Convention rules in calculating his United States tax.