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

taxation of interest.

Paragraph 1 grants to the residence State the exclusive right to tax interest derived and beneficially owned by its residents. Thus, the exemption at source for interest in the prior Convention is generally carried forward to this Convention.

Unlike the prior Convention which did not explicitly define "interest”, under the new treaty, paragraph 2 of Article 11 expansively defines the term "interest" as used in this Article to mean income from debt-claims of every kind, whether or not the claim is secured by a mortgage, and whether or not carrying a right to participate in the profits of the debtor. The definition of interest includes income from Government securities and from bonds or debentures, including premiums or prizes attaching to such securities, bonds or debentures. The definition also encompasses an excess inclusion with respect to a residual interest in a real estate mortgage investment conduit. A special rule is provided in paragraph 7 for this category of interest. Penalty charges for late payment are excluded from the definition of interest. Interest does not include dividends as defined in Article 10 even if such dividends are income arising from debt-claims.

Paragraph 3 provides an exception to the general rule of paragraph 1 that bars a source country tax on interest. The exception applies in cases where the beneficial owner of the interest carries on business through a permanent establishment in the source State or performs independent personal services from a fixed base situated in the source State and the debt claim in


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respect of which the interest is paid forms part of the business property of such permanent establishment or fixed base. In such cases the provisions of Article 7 (Business profits) or Article 14 (Independent personal services) will apply and the source State will generally retain the right to impose tax on such interest income.

Paragraph 4 provides a source rule for interest. It provides

that interest shall be deemed to arise in a State when the payer is the State itself, or a political subdivision, local authority or resident of that State. There is an exception, however, to the general rule that interest arises in the State of residence of the payer. The exception arises when the payer, even if he is a thirdstate resident, has a permanent establishment or a fixed base in one of the States and the interest is borne by that permanent establishment or fixed base. In that case, the interest is deemed to arise in the State in which the permanent establishment or fixed base is situated.

Paragraph 5 deals with cases where there is a special relationship between the payer and the beneficial owner of interest. The provisions of Article 11 apply only to interest payments that would have been made absent such special relation ships ( 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 Sweden respectively, 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 to the rate limitations of paragraph 2 of Article 10 (Dividends).

Paragraph 6 limits the right of one State to impose tax on interest payments made by a resident of the other. The paragraph provides for the imposition of tax under those circumstances only with respect to (1) interest paid to a resident of the firstmentioned State, (2) interest attributable to a permanent establishment or a fixed base located in that first-mentioned state, or (3) interest that arises in the first-mentioned State and is not paid to a resident of the other State. Thus, under subparagraph (a), the United States may tax interest paid by a Swedish resident to a resident of the United States as part of the world-wide income of the U.S. resident. Under subparagraph (b), the United States may tax interest paid by a resident of Sweden if that interest is attributable to a permanent establishment located in the United States, and is therefore subject to U.S. tax as part of the income of the permanent establishment. Finally, under subparagraph (c), the United States may tax interest paid by a resident of Sweden if (1) that interest is borne by a U.S. permanent establishment of that Swedish resident, (2) it is not portfolio interest or otherwise exempt from U.S. tax, and (3) the beneficial owner of the interest is a resident of a country that does not have a treaty


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with the United States that exempts interest from tax at source. For example, if a U.S. permanent establishment of a Swedish company borrows from a Swiss bank, interest paid on that loan would be U.S. source, and would be subject to tax at a rate of 5 percent under the U.S.-Switzerland treaty. No tax, however, would be imposed by the United States on the permanent establishment of the Swedish company under the excess interest provisions of section 884(f) of the Code, since excess interest is treated in this case as interest paid by a resident of the United States to a resident of Sweden, and such interest is exempt from U.S. tax under paragraph 1 of this Article.

Although paragraph 2 includes an excess inclusion with respect to a residual interest in a U.S. real estate mortgage investment conduit (REMIC) within the definition of interest, paragraph 7 provides that the exemption at source for interest provided for in paragraph 1 does not apply to such income. Instead, such income may be taxed in the State where the excess inclusion arises. Under United States law, this class of income is subject to the statutory 30 percent U.S. rate of tax at source. The legislation that created REMICs in 1986 provided that such excess inclusions were to be taxed at the full 30 percent statutory rate, regardless of any then-existing treaty provisions to the contrary. Providing for the 30 percent rate in the Convention, therefore, conforms the treatment of excess inclusions with respect to residents of Sweden to Congressional intent.

Notwithstanding the limitations on source country taxation of interest contained in this Article, the saving clause of paragraph 4 of Article 1 (Personal scope) permits the United States to tax interest received by 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 effect.

As with any benefit of the Convention, a resident of one of the States claiming the benefit of this Article must be entitled to the benefit under the provisions of Article 17 (Limitation on benefits).