Article 7 - BUSINESS PROFITS

This Article provides rules for the taxation by one of the States of the business profits of an enterprise of the other. Paragraph 1 contains the basic rule that business profits of an enterprise of one State may not be taxed by the other State unless the enterprise carries on business in that other State through a permanent establishment (as defined in Article 5 (Permanent establishment)) situated there. Where this condition is met, the State in which the permanent establishment is situated may tax the income of the enterprise, but only so much of the income as is attributable to the permanent establishment. This rule is broadly similar to the rule in the prior Convention.

Paragraph 2 provides rules for the attribution of business profits to a permanent establishment. It provides that the Contracting States will attribute to a permanent establishment the profits that it would have earned had it been an independent entity, engaged in the same or similar activities under the same or similar circumstances. The computation of the business profits attributable to a permanent establishment under this paragraph is subject to the rules of paragraph 3 for the allowance of expenses incurred for the purpose of earning the income. The profits attributable to a permanent establishment may be from sources within or without a Contracting State. Thus, certain items of foreign source income described in Code section 864(c)(4)(B) may be attributed to a U.S. permanent establishment of a Swedish enterprise and subject to tax in the United States. The concept of "attributable to" in the Convention is narrower than the concept of "effectively connected" in Code section 864(c). The limited "force of attraction" rule in Code section 864(c)(3) is not applicable under the Convention.

Paragraph 2 differs in one respect from the comparable paragraph in many recent U.S. treaties, but conforms in this respect to the OECD Model. In certain other U.S. treaties, the permanent establishment is treated as if it were a "distinct and independent enterprise," and the reference to it dealing wholly independently with the enterprise of which it is a permanent establishment is deleted. The language in other U.S. treaties is intended to make clear that, as described in paragraph 10 of the OECD Commentaries to Article 7, the permanent establishment is to

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be treated as if it were a totally independent enterprise, i.e., one that deals independently with all related companies, not just its home office. In the course of the negotiations, the Swedish negotiators made clear that they subscribed to the interpretation in the OECD Commentaries, but preferred to retain, at least in part, the language from the OECD Model. Thus, there should be no difference in application between paragraph 2 of Article 7 and its analogue in other U.S. treaties.

Paragraph 3 of the Article provides that in determining the

business profits of a permanent establishment, deductions shall be allowed for expenses incurred for the purposes of the permanent establishment. Deductions are to be allowed regardless of where the expenses are incurred. The paragraph specifies that among the expenses for which deductions are allowed are a reasonable allocation of expenses for research and development, interest and other similar expenses. Also included is a reasonable allocation of executive and general administrative expenses.

Paragraph 4 provides that no business profits will be attributed to a permanent establishment merely because it purchases goods or merchandise for the enterprise of which it .is a permanent establishment. This rule refers to a permanent establishment that performs more than one function for the enterprise, including purchasing. For example, the permanent establishment may purchase raw materials for the enterprise's manufacturing operation and sell the manufactured output. While business profits may be attributable to the permanent establishment with respect to its sales activities, no profits are attributable to its purchasing activities. If the sole activity were the purchasing of goods or merchandise for the enterprise the issue of the attribution of income would not arise, because, under subparagraph 4(d) of Article 5 (Permanent establishment), there would be no permanent establishment.

Paragraph 5 provides that only those business profits derived from a permanent establishment's assets or activities are to be attributed to the permanent establishment. This rule clarifies, as noted in connection with paragraph 2 of the Article, that the Code's limited "force of attraction" principle is not incorporated into the Convention. To assure continuous and consistent tax treatment, the same method for determining the profits of a permanent establishment is to be used from year to year, unless there is good reason to change.

Paragraph 6 explains the relationship between the provisions of Article 7 and other provisions of the Convention. Under paragraph 6, where business profits include items of income that are dealt with separately under other articles of the Convention, the provisions of those articles will, except where they specifically provide to the contrary, take precedence over the provisions of Article 7. Thus, for example, the taxation of interest will be

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determined by the rules of Article 11 (Interest), and not by Article 7, unless, as provided in paragraph 3 of Article 11, the interest is attributable to a permanent establishment, in which case the provisions of Article 7 apply.

Paragraph 7 provides a definition of "profits." The term is defined to mean income derived from any trade or business carried on by any person or group of persons. With one exception, the definition of business profits used in many U.S. treaties is retained in paragraph 7, including specifically the reference to income from the rental of tangible personal (movable) property. The definition does not, however, define film rentals as profits. Instead, film rentals are considered royalties under paragraph 2 of Article 12 (Royalties). There is little substantive significance in classifying film rentals under Article 12 instead of Article 7. Under both articles, film rentals are taxed exclusively by the residence country, unless they are attributable to a permanent establishment or a fixed base, in which case they may be taxed on a net basis in the country in which the permanent establishment or fixed base is located.

Paragraph. 8 clarifies that the U.S. Federal excise tax on insurance or reinsurance premiums paid to foreign insurers will not be imposed on insurance premiums paid to an insurance business carried on by a Swedish enterprise, whether or not the business is carried on through a U.S. permanent establishment. The U.S. waiver of excise taxes applies only to the extent that the relevant risk is not reinsured, directly or indirectly, with a person not entitled to relief from such tax. Reinsurance of a relevant risk includes reinsurance against, or with respect to, underlying hazards, risks, losses, or liabilities within the United States. For example, the waiver would not be available if an underlying U.S. risk were reinsured or retroceded by a Swedish insurer to a Swiss insurer, because the U.S.-Switzerland income tax convention does not provide for a waiver of these U.S. excise taxes. Paragraph 8(b) states the corresponding rule for Swedish excise taxes on insurance premiums. Sweden does not impose an excise tax on reinsurance premiums.

The U.S. negotiators agreed to waive these excise taxes only after a review of Swedish law indicated that the income tax imposed by Sweden on Swedish resident insurers results in a burden that is substantial in relation to the U.S. tax on U.S. resident insurers. On the basis of this analysis, U.S. negotiators concluded that it was appropriate to waive the U.S. excise taxes in this Convention.

The waiver of the U.S. excise tax in paragraph 8 merely restates the result that obtains under a combination of U.S. law and other provisions of the Convention. The nited States may not, pursuant to the provisions of paragraph 1 of Article 7, impose the excise tax on the income of any Swedish enterprise that is not attributable to a permanent establishment in the United States.

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Under Code section 4373, the tax may not be imposed on any amount that is effectively connected with the conduct of a trade or business in the United States (unless that amount is exempt from net basis U.S. income tax pursuant to a treaty obligation of the United States). Since any amount attributable, under the Convention, to a permanent establishment in the United States will also be effectively connected with a U.S. trade or business, the tax may also not be imposed on any income of a Swedish enterprise that is attributable to a permanent establishment in the United States.

Paragraph 9 clarifies that any income, gain or expense attributable to a permanent establishment during its existence is taxable or deductible in the State in which the permanent establishment is situated even if the payment is deferred until after the permanent establishment no longer exists. This paragraph incorporates into the Convention the rule of Code section 864(c)(6).

This Article is subject to the saving clause of paragraph 3 of Article 1 (Personal scope). Thus, if, for example, a citizen of the United States who is a resident of Sweden derives business profits from the United States that are not attributable to a permanent establishment in the United States, the United States may (subject to the special foreign tax credit rules of paragraph 3 of Article 23 (Relief from double taxation)) tax those profits as part of the worldwide income of the citizen, notwithstanding the fact that this Article generally would exempt such income of a Swedish resident from U.S. tax.

As with any benefit of the Convention, the enterprise claiming the benefit of Article 7 must be entitled to the benefit under the provisions of Article 17 (Limitation on benefits).