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

State. Several important rules regarding the taxation of busi­ ness profits are found in the Protocol. These are discussed in

this explanation of Article 7.

Paragraph 1

   Paragraph 1 contains the basic rule that business profits of
an enterprise of one Contracting State may not be taxed by the
other Contracting 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 estab­
lishment is situated may tax the business profits of the enter­
prise that are attributable to the assets or activities of the
permanent establishment.

   Under Point II of the Protocol, in certain circumstances,
the State in which the permanent establishment is situated may
also tax business profits derived from the sale of goods or
merchandise or the provision of services even if the assets and

activities of the permanent-establishment were not involved in the sale or services. This limited "force of attraction" rule is

similar to, but narrower than, a rule found in the U.N. Model and
is also similar to provisions that appear in the U.S. treaties

with Mexico, Indonesia, and India. Under the Protocol rule, if

an enterprise of one Contracting State derives income from the
sale of goods or the carrying on of other business activities

through a permanent establishment situated in the other Contract­

ing State, certain income derived directly by the enterprise

:isg_, not through the permanent establishment) from the sale of

goods of the same or similar kind as those sold through the
permanent establishment or from the carrying on of activities of

the same or similar kind as those carried on through the perma­ nent establishment may be attributed to the permanent estab­ lishment. Some countries, using the U.N. Model, request a force

of attraction rule to prevent avoidance of their tax at source.
Unlike the U.N. Model provision on which it is based, the force

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of attraction rule in this Convention is limited to situations in
which it can be proved that the transaction giving rise to the
income was structured to avoid taxation in the country in which
the permanent establishment is situated. For example, if the
Istanbul office of a U.S. consulting firm provides certain
services to small companies in Turkey and a very large Turkish
company requires similar services but on a scale too large for
the permanent establishment to handle, the Turkish company might
enter into a contract with the consulting firm's home office in
the United States to provide those services directly. The income
from that transaction would not be attributed to the permanent
establishment because it could not be shown that the transaction
was structured through the U.S. office in order to avoid Turkish
tax. If, however, some small Turkish companies are served by the
Istanbul office and other similar-sized companies are served
directly from the United States, it might be possible to prove
that services were carried out through the home office to avoid
Turkish tax. If such a case were made, the income from these
contracts with the home office would be attributed to the perma­
nent establishment.

Protocol Point V

   Point V of the Protocol clarifies that income or gain may be
attributable to a permanent establishment and may be taxed 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 same deferred payment rule applies with
respect to income from independent personal services attributable
to a fixed base under Article 14 (Independent Personal Services).
The deferred income rule also applies for purposes of determining
whether income is attributable to a permanent establishment or
fixed base under paragraph 5 of Article 10 (Dividends), paragraph
5 of Article 11 (Interest), paragraph 4 of Article 12 (Royal­
ties), and paragraph 2 of Article 21 (Other Income) and whether
gain is from the alienation of personal property forming part of
the business property of a permanent establishment or a fixed
base under paragraph 3 of Article 13 (Gains). This paragraph
incorporates into the Convention the rule of Code section 864(c)­
(6)­

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Paragraph 2

   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 takes into
account the expenses that are deductible in accordance with the

rules of paragraph 3. 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) or (C) may be attributed to a U.S. permanent establishment of a Turkish 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 attrac­
tion" rule in Code section 864(c)(3), therefore, is not applica­
ble under the Convention to the extent that it is broader than
the rule of Point II of the Protocol.

   Paragraph 2 differs in one respect from the comparable
paragraph in the OECD Model, which speaks of treating a permanent

establishment as if it were a "distinct and separate enterprise,"

and refers to it as dealing wholly independently with the enter­

prise of which it is a permanent establishment. The language in

paragraph 2 of this Convention is intended to make clear that the
permanent establishment is to be treated as if it were a totally

independent enterprise, i.e., one that deals independently with

all related companies, or with other permanent establishments of
the enterprise, not just its home office.

   Paragraph 3

    Paragraph 3 of the Article complements paragraph 2 by
providing rules for determining the amount of income attributable
to a permanent establishment. Paragraph 3 provides that in

determining the business profits of a permanent establishment,

deductions shall be allowed for expenses incurred for the purpos­

es of the permanent establishment. Deductions are to be allowed

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regardless of where the expenses are incurred and regardless of
whether they are incurred directly by the permanent establishment
or whether they are actually reimbursed by the permanent
establishment. Unlike many U.S. treaties, the paragraph does not
specify that deductions are to be allowed for a reasonable
allocation of expenses. However, as indicated in paragraph 16 of
the OECD Commentary to Article 7, certain expenses may be esti­
mated and allocated. The United States, for example, allocates
interest expense under the rules of Code section 882 and will
continue to do so under the treaty.

   Point III of the Protocol clarifies, as does the UN Model
and the Commentary to the OECD Model, that payments of interest,
royalties, commissions and other similar payments by a permanent
establishment to its head office or to other permanent establish­
ments of the enterprise will be allowed as deductions only to the
extent that they represent reimbursements of actual expenses.
The point of this provision is to clarify that because the head
office and the permanent establishment are parts of a single
entity, there should be no profit element in intra-company
transfers. To the extent, therefore, that a payment includes
what would normally be a profit element (e.a., that part of a
royalty payment that represents profit of the owner of the

intangible, as opposed to the part that is a reimbursement for the costs of developing the intangible), it will not be deduct­ ible. The Protocol rule does not require that payments be specifically traceable to the permanent establishment to be deductible nor does it require that traced payments be deductible

Paragraph 4

Paragraph 4 provides that no profits will be attributed to a

permanent establishment merely because it purchases goods or
merchandise for the enterprise of which it is a permanent estab­

lishment. This rule refers to a permanent establishment that
performs more than one function for the enterprise, including
purchasing. For example, the permanent establishment may pur­
chase 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

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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 3 .d) of Article 5 (Permanent Establishment), there would be no permanent

establishment.

Paragraph 5

   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 Arti­ cle) that the Code's limited "force of attraction" principle is

not incorporated into the Convention. Where it is applicable,

Point II of the Protocol takes precedence over paragraph 5.

   Paragraph 6

   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 specifi­

cally provide to the contrary, take precedence over the provi­ sions of Article 7. Thus, for example, the taxation of interest

will be determined by the rules of Article 11 (Interest), and not
by Article 7 unless, as provided in paragraph 5 of Article 11,

the interest is attributable to a permanent establishment, in

which case the provisions of Article 7 will apply.

   Protocol Point IV

As discussed in the explanation to paragraph 2 of Article 5

(Permanent Establishment), point IV of the Protocol deals with

the taxation of income from offshore mineral exploration. Point

IV first clarifies that income from these activities is business
profits or independent personal services income. As such, the
income is generally only taxable by the non-resident State if it
is attributable to a permanent establishment in that State.

Under the provisions of Point IV, the mere presence in a country

of an installation, drilling rig or ship for carrying out mineral

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exploration or exploitation does not give rise to a permanent

establishment. Business profits will nonetheless be taxable in the country where the exploration activity takes place if either (i) there is a permanent establishment, other than the installa­

tion, rig or ship, through which the income-generating activities

are performed or (ii) the period during which the exploration

activities or services are performed exceeds 183 days in a

continuous 12-month period. While application of Protocol Point

IV does not technically result in a permanent establishment, it
does treat an enterprise that exceeds the 183-day threshold
analogously to an enterprise that has a permanent establishment
in the host country.

   Relation to other articles

   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 Turkey derives business

profits from the United States that are not attributable to a

permanent establishment in the United States, the United States

may 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 Turkish resident from U.S. tax.

As with other benefits-of the Convention, the enterprise

claiming the benefit of Article 7 must be entitled to the benefit

under the provisions of Article 22 (Limitation on Benefits).