Article 17 addresses the problem — U.S. Income Tax Treaty

limiting the source basis tax benefits of the Convention to those residents of the other Contracting State that have a substantial nexus with, or otherwise have a significant business purpose for residing in, the other Contracting State. In a typical case of treaty shopping, a resident of a third State might establish an


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entity resident in a Contracting state for the purpose of deriving income from the other Contracting State and claiming treaty benefits with respect to that income. Article 17 limits the abuse of the Convention by limiting the benefits of the Convention to those persons whose residence in a Contracting State is not considered to have been motivated by the existence of the Convention. Absent Article 17, the entity generally would be entitled to benefits under the treaty as a resident of a Contracting State, although the entity might be denied those benefits as a result of limitations (e.q., business purpose, substance-over-form, step transaction or conduit principles or other anti-avoidance rules) applicable to a particular transaction or arrangement. Article 17 and the general anti-abuse provisions complement each other, as Article 17 generally determines whether an entity has a sufficient nexus to the Contracting State to be treated as a resident for treaty purposes, while general anti-abuse provisions determine whether a particular transaction should be recast in accordance with the substance of the transaction.

The structure of Article 17 is as follows: Paragraph 1 lists a series of attributes of a resident of a Contracting State, the presence of any one of which will entitle that person to benefits of the Convention in the other Contracting State. Several of these, which will be discussed first, are purely objective tests. One, in subparagraph (c), is more subjective, and requires some elaboration and interpretation. Paragraph 2 provides that benefits may be granted even to a person not entitled to benefits under the tests of paragraph 1, if the competent authority of the source State so determines. Paragraph 3 defines the term "recognized stock exchange" as used in paragraph 1. Paragraph 4 authorizes the competent authorities to develop agreed applications of the Article and to exchange information necessary for carrying out the provisions of the Article.

Two categories of persons eligible for benefits from the other Contracting State under subparagraphs (a) and (b) of paragraph 1 are (1) individual residents of a Contracting State and (2) the Contracting States, political subdivisions or local authorities thereof. It is most unlikely that persons falling into these two categories can be used to derive treaty benefitted income, as the beneficial owner of the income, on behalf of a third-country person. If an individual is receiving income as a nominee on behalf of a third-country resident, benefits will be denied with respect to those items of income under the articles of the Convention which grant the benefit, because of the requirements in those articles that the beneficial owner of the income be a resident of a Contracting State.

Subparagraph (d) provides a two-part test, the ownership and base erosion tests, both of which must be met for entitlement to benefits under this subparagraph. Under these tests, benefits will be granted to a resident of a Contracting State other than an


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individual, if both (1) more than 50 percent of the beneficial interest in the person (or, in the case of a corporation, more than 50 percent of each class of its shares) is owned, directly or indirectly, by persons who are themselves entitled to benefits under the other tests of paragraph 1 (other than subparagraph (c)), or by U.S. citizens, and (2) not more than 50 percent of the person's gross income is used, directly or indirectly, to make deductible payments to persons, other than persons who are themselves eligible for benefits under the other tests of paragraph 1 (other than subparagraph (c) ), or to U.S. citizens. It is understood that the term "gross income" is to be interpreted as in U.S. law. Thus, in general, the term should be understood to mean gross receipts less cost of goods sold.

The rationale for this two-part test is that since treaty benefits can be indirectly enjoyed not only by equity holders of an entity, but also by that entity's various classes of obligees (such as lenders, licensors, service providers, insurers and reinsurers) it is not enough merely to require substantial ownership of the entity by treaty country residents or their equivalent. In order to prevent treaty benefits from inuring to third-country residents, it is also necessary to require that the entity's deductible payments be made in substantial part to such treaty country residents or their equivalents. For example, a third-country resident could lend funds to a Swedish-owned Swedish corporation to be reloaned to a resident of the United States that is related to the third-country resident. In the absence of a treaty between the United States and the third country, the interest if earned directly by the third-country resident would be subject to a 30 percent withholding tax in the United States. The U.S. source interest income of the Swedish corporation, however, would be exempt from U.S. withholding tax under Article 11 (Interest) of the Convention. While the Swedish corporation would be subject to Swedish corporation income tax, its taxable income could be reduced to near zero by the deductible interest paid to the third-country resident. If, under a Convention between Sweden and the third country, that interest is exempt from Swedish tax, the U.S. treaty benefit with respect to the U.S. source interest income will have flowed to the third-country resident.

Under subparagraph (e), a corporation that is a resident of a Contracting State is entitled to treaty benefits from the other Contracting State if there is substantial and regular trading in the corporation's principal class of shares on a recognized stock exchange. The term "recognized stock exchange" is defined in paragraph 3 of the Article to mean, in the United States, the NASDAQ System and any stock exchange which is registered as a national securities exchange with the Securities and Exchange Commission, and, in Sweden, the Stockholm Stock Exchange (Stockholms Fondbörs). Paragraph 3 also provides that the competent authorities may, by mutual agreement, recognize additional exchanges for purposes of subparagraph 1(e).


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Subparagraph (f) provides that a not-for-profit organization (including a pension fund and a private foundation) which is a resident of a Contracting State is entitled to benefits from the other Contracting State if it satisfies two conditions: (1) It must be generally exempt from tax in its State of residence by virtue of its not-for-profit status, and (2) more than half of the beneficiaries, members or participants, if any, in the organization must be persons entitled, under this Article, to the benefits of the Convention. A pension fund is entitled to the benefits of the Convention if the organization sponsoring the fund, trust or entity is entitled to the Convention's benefits under Article 17. Thus, one need not determine that more than half of the beneficiaries of a Swedish pension plan are residents of Sweden in deciding whether the plan is entitled to U.S. treaty benefits in respect of its income so long as the Swedish corporation sponsoring the fund is entitled to benefits under Article 17, because, for example, it is publicly traded on the Stockholm Stock Exchange. If, however, the sponsoring organization is not entitled to benefits, the tests of subparagraph 1(f) must be met.

Subparagraph 1(c) of Article 17 provides a test for eligi bility for benefits for residents of a Contracting State that are not qualifying persons under any of the other tests of this paragraph. This is the so-called "active trade or business" test. Unlike the other tests of paragraph 1, it looks not solely at objective characteristics of the person deriving the income, but at the nature of the activity engaged in by that person and the connection between the income and that activity. Under the active trade or business test, a resident of one State deriving an item of income from the other State is entitled to benefits with respect to that income if that person (or a person related to that person) is engaged in an active trade or business in the first-mentioned State and the income in question is derived in connection with, or is incidental to, that trade or business.

Income that is derived in connection with, or is incidental to, the business of making or managing investments will not qualify for benefits under this provision, unless those investment activities are banking or insurance activities carried on by a bank or insurance company.

Income is considered derived "in connection" with an active trade or business in a Contracting State if, for example, the income-generating activity in that State is "upstream," "downstream," or parallel to that going on in the other State. Thus, if the U.S. activity consisted of selling the output of a Swedish manufacturer or providing inputs to the manufacturing process, or of selling in the United States the same sorts of products that were being sold by the Swedish trade or business in Sweden, the income generated by that activity would be treated as earned in connection with the Swedish trade or business. Income would be considered "incidental" to the Swedish trade or business if, for


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example, it were interest income earned from the short-term investment of working capital of the Swedish resident in U.S. securities.

An item of income will be considered to be earned in connection with or to be incidental to an active trade or business in Sweden if the income is derived by the resident of Sweden claiming the benefits directly or indirectly through one or more other persons that are residents of the United States. Thus, for example, a Swedish resident could claim benefits with respect to an item of income earned by a U.S. operating subsidiary but derived by the Swedish resident indirectly through a U.S. holding company interposed between it and the operating subsidiary.

It is expected that, in order for an item of income to be considered derived in connection with an active trade or business under subparagraph 1(c), the business activity in the residence State will be substantial in relation to the income generating activity in the source State. For example, the trade or business in Sweden must be substantial in relation to the activity in the United States that gave rise to the income in respect of which treaty benefits are being claimed. Given the relative sizes of the U.S. and Swedish economies, it is not necessary that the Swedish trade or business be as large as the U.S. income-generating activity. The Swedish trade or business cannot, however, in terms of income, assets, or similar measures, be only a very small percentage of the size of the U.S. activity.

The substantiality requirement is intended to prevent certain types of treaty-shopping abuses. For example, a third-country resident may want to acquire a U.S. company that manufactures television sets for worldwide markets; however, since its country of residence has no tax treaty with the United States, any dividends generated by the investment would be subject to a U.S. withholding tax of 30 percent. Absent a substantiality test, the investor could set up a Swedish corporation that would operate a small outlet in Sweden to sell a few of the television sets manufactured by the U.S. company. That Swedish corporation would then acquire the U.S. manufacturer with capital provided by the third-country resident. It might be argued that the U.S. source income is generated from business activities in the United States related to the television sales activity of the Swedish parent and that the dividend income should be subject to U.S. tax at the 5 percent rate provided by Article 10 (Dividends). However, the substantiality test would not be met in this example, so the dividends would remain subject to withholding in the United States at a rate of 30 percent.

In general, it is expected that if a person qualifies for benefits under the other subparagraphs of paragraph 1, no inquiry will be made into qualification for benefits under subparagraph 1(c). Upon satisfaction of any of the other tests of paragraph 1,


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any income derived by the beneficial owner from the other Contracting State is entitled to treaty benefits. Under subparagraph 1(c), however, the test is applied separately for each item of income.

It is intended that the provisions of subparagraph 1(c) will be self executing. Unlike the provisions of paragraph 2, discussed below, claiming benefits under this subparagraph does not require advance competent authority ruling or approval. The tax authorities may, of course, on review determine that the taxpayer has improperly interpreted the subparagraph and is not entitled to the benefits claimed.

Paragraph 2 provides that a resident of a Contracting State that derives income from the other Contracting State and is not entitled to the benefits of the Convention under any of the provisions of paragraph 1, may, nevertheless, be granted benefits at the discretion of the competent authority of the Contracting State in which the income arises.

Paragraph 2 itself provides no guidance to competent authorities or taxpayers as to how the discretionary authority is to be exercised. It is understood, however, that in making determinations under paragraph 2, the competent authorities will take into account all relevant facts and circumstances. The factual criteria that the competent authorities are expected to take into account include the existence of a clear business purpose for the structure and location of the income earning entity in question; the conduct of an active trade or business (as opposed to a mere investment activity) by such entity; and a valid business nexus between that entity and the activity giving rise to the income.

For purposes of implementing paragraph 2, a taxpayer will be permitted to present his case to his competent authority for an advance determination based on the facts, and will not be required to wait until the tax authorities of one of the Contracting States have determined that benefits are denied under one of the other provisions of the Article. It also is expected that if the competent authority determines that benefits are to be allowed, they will be allowed retroactively to the time of entry into force of the relevant treaty provision or the establishment of the structure in question, whichever is later.

It is contemplated that under paragraph 2 the Competent Authority of the United States will grant treaty benefits to the Nobel Foundation, a Swedish charitable organization.

Paragraph 4 provides that the competent authorities of the United States and Sweden will consult together to develop a commonly agreed application of this Article. In accordance with Article 26 (Exchange of information), the competent authorities


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will exchange information necessary to carry out this Article and to safeguard the application of domestic laws.