Article 11. INTEREST

Article 11 provides rules for source and residence State taxation of interest.

Paragraph 1 grants to the residence State the exclusive right to tax interest derived and beneficially owned by its

residents. Thus, this Convention generally preserves the exemp­
tion at source for interest provided in the **1956** Convention. As
in the case of Article **10** (Dividends), the source State shall

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treat as the beneficial owner of such income the person to which

the income is attributable for tax _purposes_ under the laws of the
source State. Interest arising in a Contracting State and paid
to a nominee or agent that is a resident of the other Contracting
State therefore may be taxed in the State of source if the
beneficial owners are not residents of the other Contracting
State (subject to the provisions of any applicable treaty between

the State of source and the State of residence of the beneficial

owner).

Paragraph 2 defines the term "interest" as used in the
Convention to include, inter Alia, income from debt claims of
every kind, whether or not secured **by** a mortgage, and whether or
not carrying a right to participate in the debtor's profits. The

term includes, in particular, income from government securities and income from bonds or debentures, including premiums or prizes

attaching to these instruments. Penalty charges for late payment
are not defined as interest, but an excess inclusion with respect
to a residual interest in a real estate mortgage investment
conduit is defined as interest (see paragraph **5).** Any income

dealt with in Article 10 is also excluded from the definition of interest. Thus, for example, if under domestic law of the source State, income from a debt obligation carrying the right to participate in profits is treated as a dividend, it is also treated as a dividend under paragraph 3 of Article 10 and is not covered by Article 11. Such income that is not treated as a dividend under the law of the source State, however, remains within the definition of interest Under Article 11.

Paragraph **3** provides an exception from the source-State

exemption rule of paragraph 1 in cases where the beneficial owner of the interest carries on business through a permanent estab­

lishment in the source State or performs independent personal
services from a fixed base situated in the source State and the
debt claim in respect of which the interest is effectively

connected with the 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 a net basis on such interest income. This rule conforms to the OECD Model. The rule in paragraph 9 of Article 7 (Business Profits) applies to this paragraph as well, so that interest attributable to a permanent establishment or fixed base, but received after the permanent establishment or fixed base no

longer exists, will, nevertheless, be taxable in the Contracting State in which the permanent establishment or fixed base existed.

Paragraph 4 limits the benefits of this Article to interest

amounts that reflect arm's length transactions. If the interest paid exceeds an arm's length amount due to a special relationship between the debtor and creditor, then any excess amount of

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interest paid remains taxable according to the laws of the source
State 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 .5provides exceptions to the general exemption from source-State taxation of interest. Paragraph 5(a) permits the United States to impose its statutory rate of tax (currently 30 percent) on an excess inclusion with respect to a residual

interest of an Austrian resident in a **U.S.** real estate mortgage

investment conduit (REMIC), notwithstanding the provisions of

paragraphs **1** and 2 that generally exempt interest from taxation

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 to Congressional intent the treatment of excess inclusions with respect to residents of Austria. It is consistent with the policy of Code sections 860E(e) and 860G(b) that excess inclusions with respect to a real estate mortgage investment conduit (REMIC) should bear full U.S. tax in all cases. Without a full tax at source, foreign purchasers of residual interests would have a competitive advantage over U.S. purchasers at the time these interests.are initially offered. Also, absent this rule, the U.S. would suffer a revenue loss with respect to mortgages held in a REMIC because of opportunities for tax avoidance created by differences in the timing of taxable and economic income produced by these interests.

The second exception, in subparagraph 5(b), deals with contingent interest of the type that does not qualify as portfolio interest under U.S. law and to analogous types of interest under Austrian law. Under this provision, interest arising in one of the Contracting States that is determined by reference to the receipts, sales, income, profits or other cash flow of the debtor or a related person, to any change in the value of any property of the debtor or a related person or to any dividend, partnership distribution or similar payment made by the debtor to a related person, and paid to a resident of the other State may also be taxed in the Contracting State in which it arises, and according to the laws of that State, but if the beneficial owner is a resident of the other Contracting State, the gross amount of the interest may be taxed at a rate not exceeding the rate prescribed in subparagraph (b) of paragraph 2 of Article 10 (Dividends).

The Article does not refer to the excess of the amount of interest deductible by a permanent establishment of an Austrian

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company in the United States over the interest actually paid by

such permanent establishment (i.., the excess interest portion
of the branch level interest taxes imposed **by** section 884(f) of
the Code). Since this amount is treated as .interest derived and
beneficially owned **by** the resident of Austria, the Article **11**

exemption from source country taxation will generally prevent the collection of this excess interest tax.

Notwithstanding the foregoing limitations on source State

taxation of interest, the saving clause of paragraph 4 of Article
**1** (Personal Scope) permits the United States to tax its residents

and citizens, subject to the special foreign tax credit rules of

paragraph 2 of Article 22 (Relief from Double Taxation, as if the
Convention had not come into force. As with all benefits under

this Convention, the granting of benefits under this Article is subject to the requirement that the beneficial owner of the interest income qualify for benefits under the provisions of Article 16 (Limitation on Benefits).