Article 16 addresses the problem of "treaty shopping." The
U.S. Income Tax Treaty — Technical Explanation - 1996 · 2026-10-03 edition · updated 2026-10-04 · United States
Article ensures that only those persons intended to benefit from
the Convention -- residents of the other Contracting State -- do so, by not granting benefits that will ultimately enure to the benefit of residents of third States that do not have a substantial business in, or business nexus with, that other Contracting State.
In a typical case of treaty shopping, a resident of a third
State wants to derive treaty-favored income from one of the
Contracting States, but has no treaty, or has an unfavorable treaty, with. that State. The third-country resident would establish an entity resident in the other Contracting State principally for the purpose of deriving income from the first``` mentioned Contracting State and claiming treaty benefits with
respect to that income. Article **16** seeks to deny benefits to
such persons by limiting the benefits of the Convention to those persons whose residence in a Contracting State is unlikely to have been motivated by the existence of the Convention. Absent Article 16, the entity described in the preceding paragraph generally would be entitled to benefits as a resident of a Contracting State, subject, however, to anti-abuse
provisions (eg_, business purpose, substance-over-form, step
transaction or conduit principles) that may apply to the transaction or arrangement under the domestic law of the source
State. As noted in the Memorandum of Understanding, Article **16**
and the anti-abuse provisions of domestic law complement each other, as Article 16 generally determines whether an entity has sufficient nexus to the Contracting State to be treated as a resident for treaty purposes, while domestic anti-abuse provisions determine whether a particular transaction should be
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recast in accordance with the substance <sup>of</sup> <sup>the</sup> transaction.
The structure of the Article is as follows: Paragraph **1**
lists a series of attributes, any one of which will entitle a
person who is a resident of a Contracting State to some or all of
the benefits of the Convention in the other Contracting State.
These tests are essentially objective tests. Paragraph 2 pro
vides 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 State in which the relevant income arises so
determines. Paragraph **3** defines the term "recognized stock
exchange." Paragraph 4 addresses "triangular cases." Paragraph **5**
authorizes the competent authorities to develop agreed applica
tions and to exchange information necessary for carrying out the
provisions of the Article.
The negotiators developed a Memorandum of Understanding indicating how the provisions of the Article are to be understood both by the competent authorities and by taxpayers in the Con
tracting States. It is anticipated that as the competent author
ities and taxpayers gain more experience with the concepts in
this Article further guidance will be developed and made public.
The Memorandum of Understanding discusses the anti-abuse
concept of the treaty, making the point that the treaty provi sions designed to curb abusive international transactions and to exclude income from those transactions from treaty benefits do
not prevent a Contracting State from applying a "substance over
form" evaluation of the facts in cases not specifically covered
**by** an anti-abuse clause in the treaty. The phrase "substance
over form" is understood to refer to the process of looking at
the economic substance of a transaction or event rather than
solely at its legal form. This process also encompasses the
notion of taking into account the economic consideration that underlies the transactions or event.
Under subparagraphs (a) and **(b)** of paragraph **1,** two
categories of persons eligible for benefits from the other
Contracting State are (1) individual residents of a Contracting
State and (2) the Contracting States, political subdivisions or
local authorities thereof. It is unlikely that a person falling into one of these 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 receives 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 that grant the benefit, because those articles require that the beneficial owner of the income be a resident of a Contracting State.
Subparagraph 1(c) describes the "active trade or business"
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and the "substantiality" test for eligibility for benefits. This
subparagraph looks not 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 this test, a resident of a Contracting State
deriving an item of income from the other Contracting State is
entitled to benefits with respect to that item of income <sup>if</sup> the
person is engaged in an active trade or business in the State of
residence and the item of income in question is derived in
connection with, or is incidental to, that trade or business. **If**
the income is derived in connection with the trade or business, rather than being incidental to it, the trade or business must be substantial in relation to the income generating activity in the
other State. The substantiality test is needed to support the
connection between the income and the active trade or business. The test for incidental activity does not require substantiality.
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 the business is a bank or insurance company engaged in banking or insurance activities.
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, any income derived by the beneficial owner from the other Con
tracting State is entitled to treaty benefits. Under subpara
graph **1(c),** however, the test is applied separately **for** each item
of income.
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
The Memorandum of Understanding describes the understandings
reached **by** the negotiators on the intended scope of subparagraph
1(cy and illustrates some of these understandings by means of
examples. The examples are not intended to be exhaustive, but
merely to illustrate the kinds of considerations relevant in determining whether a particular case falls within the scope of subparagraph 1(c).
The Memorandum of Understanding also describes how the negotiators agreed to interpret certain terms used in subpara
graph **1(c).** **A** person resident in one **of** the States will be
considered to be engaged in an active trade or business not only
if such person is directly so engaged, but also if the person:
(i) is a partner in a partnership;
(ii) is under the beneficial control of a single person
engaged in an active trade or business in that State;
(iii) is under the beneficial control of a group of five or
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fewer persons each member of which is engaged in activity in that
State that is a component part of or directly related to the
trade or business in that State;
(iv) is a company that is a member of a group of companies
that forms, or could form, a consolidated group for tax purposes
under domestic law (as applied without regard to the residence of
such companies) and the group is engaged in an active trade or
business in that State;
(v) owns, either alone or as a member of a group of five or
fewer persons that are qualified persons or residents of an
"identified state," a controlling beneficial interest in a person
engaged if an active trade or business in the owner's State of
residence; or
(vi) is together with another person that is so engaged,
under the common control of a person or a group of five or fewer
persons. that (or, in the case of a group, each member of which)
is a qualified person or a resident of an "identified state."
The Memorandum of Understanding defines an "identified
state" as any third country that the competent authorities agree
has effective exchange of information provisions with the State
being requested to give treaty benefits. It defines "income
derived in connection with or incidental to" a trade or business
as income that comes from a line of business (or assets that are
part of that business) in Austria that forms part of a business conducted in the United States, or vice versa.
The Memorandum of Understanding clarifies, principally
through the use of a number of examples, what is meant **by** the
term "substantial." In the case of an Austrian resident deriving
income from an active trade or business in the United States
carried on **by** a related person, for that Austrian trade or
business to be considered substantial in relation to the income```
generating activity in the United States, it is not necessary
that the trade or business be as large as the U.S. incomegenerating activity. The Austrian trade or business cannot, however, in terms of gross income, assets, or similar measures, be only a very small percentage of the U.S. activity.
The substantiality requirement is intended to prevent an abuse of the active trade or business test. For example, a
third-country resident may want to acquire a U.S. motion picture
company. If its country of residence has no tax treaty with the
United States, any dividends generated by the investment would be
subject to a 30-percent U.S. withholding tax. Absent a substan tiality test, the investor could set up an Austrian corporation that would operate a small video-rental outlet in Austria to rent a few videos of the movies produced by the U.S. company. That
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Austrian corporation would then acquire the U.S. production
company 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 videorental activity of the Austrian parent and that the dividend
income should be subject to U.S. tax at the 5-percent rate
provided in Article 10 (Dividends). However, the substantiality
test would not be met in this example, so the dividends would
remain subject to the 30-percent withholding tax in the United
States.
In addition to this subjective facts and circumstances
approach to interpreting substantiality, the Memorandum of
Understanding provides a safe-harbor standard. Under the safe
harbor, in general, an activity in a State will be deemed sub
stantial in relation to the income-producing activity in the
other State if the ratios of the assets used in the firstmentioned State, gross income derived from the active business in
that State, and payroll expense for services performed in that
State to the assets, gross income, and payroll expense,
respectively, for services performed in the other Contracting
State each exceed 7.5 percent and the average of the three ratios
exceeds 10 percent. If ratio for any factor fails the 7.5
percent test, the average ratio for the preceding three years may be substituted for that factor. A similar test applies in the
recent U.S.-France income tax treaty, the U.S.-Netherlands income
tax treaty, and the proposed U.S.-Luxembourg income tax treaty.
Since the term "gross income" is not defined in the conven tion, in determining whether a person deriving income from U.S.
sources is entitled to the. benefits of the Convention, in
accordance with paragraph 2 of Article 3 (General Definitions),
the United States will ascribe the meaning to the term that it has under U.S. law. Thus, in general, the term should be under
stood to mean gross receipts (net of returns and allowances) less
the cost of goods sold. The cost of sales and operations, or
cost of goods sold, includes the sum of the direct materials,
direct labor, and overhead costs related to producing, acquiring,
storing, and handling the inventories sold during a period.
Overhead costs allocable to inventory include depreciation,
property taxes paid, amortization, employee retirement plan
expenses, or other supervisory, general, and administrative
(SG&A) expenses, to the extent these costs directly benefit or
are incurred by reason of inventory operations. The cost of
goods sold does not include expenses associated with advertising,
promotion, sales and marketing, or operating costs not related to
inventory operations.
Subparagraph 1(d) provides a two-part test, ownership and
base erosion, both of which must be met for benefits to be
granted under this subparagraph. Under these tests, benefits
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vill be granted to a resident of a Contracting State 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 who are not themselves eligible for benefits under the other tests of paragraph 1 (other than subparagraph (c)), or who are not U.S. citizens.
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, and others, merely requiring substantial ownership of
the entity by treaty country residents or U.S. citizens is not
sufficient to prevent such benefits from flowing substantially to
third-country residents. It is also necessary to require that the entity's deductible payments be made to such treaty country residents or their equivalents. For example, a third-country
resident could lend funds to an Austrian-owned Austrian
corporation to be on-lent to the United States. The U.S.-source interest income of the Austrian corporation would be exempt from U.S. withholding tax under Article 11 (Interest). While the
Austrian corporation would be subject to Austrian 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 Austria and the third country, that
interest income is exempt from Austrian tax, the U.S. treaty
benefit with respect to the U.S.-source interest income will have
flowed to the third-country resident inappropriately, with no
reciprocal benefit to the United States from the third country.
Under subparagraph 1(e) a company 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 company's principal class of shares on a recognized stock exchange. Paragraph 3 defines the term "recognized stock ex change" as the NASDAQ System and any stock exchange registered as
a national securities exchange with the U.S. Securities and Ex
change Commission, and the Vienna stock exchange. Paragraph 3 also provides that the competent authorities may, by mutual
agreement, recognize additional exchanges for purposes of sub
paragraph 1(e). The contracting States intend that the term "principal class of shares" is to be interpreted as the class of
shares that represents the majority of the voting power and value
of the company. When no single class of shares represents the majority of the voting power and value of the company, the "principal class of shares" is generally those classes that in
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the aggregate possess more than 50 percent of the voting power
and value of the company. The term "shares'! shall include
depository receipts thereof or trust certificates thereof. In
determining voting power, any shares or class of shares that are
authorized but not issued shall not be counted; and, in mutual
agreement between the competent authorities, appropriate weight
shall be given to any restrictions or limitations on voting
rights of, or entitlement to disproportionately higher
participation in, issued shares.
Subparagraph 1(f) grants benefits to a company of which no
more than five publicly-traded companies, as defined in subpara
graph 1(e), own, directly or indirectly, at least 90 percent of
their shares. Such ownership must be at least 90% by vote and
value. Each person in the ownership chain must be a resident of
a Contracting State and the owner of any remaining portion of the
company must be an individual resident of a Contracting State.
This would allow a corporation to qualify for benefits if, for
example, it is a wholly-owned subsidiary of a publicly-traded
company that satisfies the tests of subparagraph 1(e) and would,
therefore, itself qualify for benefits if it received any income
from the other Contracting State. If the ownership of any
remaining portion of the company belongs to more than one
individual, each such individual must be a resident of a
Contracting State. Therefore, up to 10% of shares are permitted
to be held by individual residents of a Contracting State.
Subparagraph 1(g) provides that a not-for-profit
organization that 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.
Subparagraph 1(h) grants benefits to a resident of a
Contracting State if that person is a .recognized headquarters company for a multinational corporate group. A person is consid ered a headquarters company for this purpose only if several
conditions, specified in the Memorandum of Understanding, are
satisfied: The person seeking such treatment must perform in its
residence State a substantial portion of the overall supervision
and administration of the group, which may include, but cannot be
principally, group financing; the person must have, and exercise,
independent discretionary authority to carry out these functions;
and it must be subject to the same income taxation rules in its
residence State as are persons engaged in the active conduct of a
trade or business, as described above in connection with the
active business test under subparagraph 1(c).
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In addition, the headquarters company must meet the follow
ing conditions: Either for the taxable year concerned, or as an
average for the preceding four years, the activities and gross
income of the corporate group that the headquarters company supervises and administers must be spread sufficiently among several countries. The group must consist of corporations resident in, and engaged in an active business in, at least five
countries or groups of countries, and the income derived in the
Contracting State of which the headquarters company is not a
resident must be derived in connection with, or to be incidental
to, that active business. The business activities carried on in
each of the five countries or groupings of countries must
generate at least 10 percent of the gross income of the group.
The business activities carried on in any one country other than
the Contracting State where the headquarters company resides may
not generate 50 percent or more of the gross income of the group.
Moreover, no more than 25 percent of the headquarters company's
gross income may be derived from the other Contracting State.
These tests also appear in the U.S.-France treaty.
The provisions of paragraph 1 are intended to be self
executing. Unlike claiming benefits under paragraph 2, discussed below, claiming benefits under this paragraph does not require advance competent authority ruling or approval. The tax authori
ties may, on review, determine that the taxpayer has improperly
interpreted the paragraph and is not. entitled to the benefits
claimed.
Paragraph 2 provides that a resident of a Contracting State
that does not qualify for benefits of the Convention under the
provisions of paragraphs 1 and 4, nevertheless, may be granted
benefits at the discretion of the competent authority of the Con
tradting State in which the income arises. The competent author
ity of the State requested to give benefits will consult with the
competent authority of the other State before denying benefits
under this paragraph.
The Memorandum of Understanding provides some discussion and
guidance as to how the discretionary authority is to be exer
cised. Relevant portions are reproduced below.
It is assumed that, 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 before making a request under this paragraph. In
these circumstances, it is also 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
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in question, whichever is later.
In making determinations under paragraph 2, it is understood that the competent authorities will take into account all rele vant facts and circumstances. The factual criteria the competent
authorities are expected to take into account include the exis
tence 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 activi
ty) by such entity; a valid business nexus between that entity
and the activity giving rise to the income and the extent to
which the entity, if it is a corporation, would be entitled to
treaty benefits comparable to those afforded by the.Convention if
it had been incorporated in the country of residence of the
majority shareholders.
The following example illustrates the application of these
principles:
Facts: Austrian, German and Belgian companies, each of
which is engaged directly or through its
affiliates in substantial active business
operations in its country of residence, decide to cooperate in the development, production and marketing of an advanced passenger aircraft through a corporate joint venture with its statutory seat in Austria. The development,
production and marketing aspects of the project
are carried out by the individual joint venturers.
The joint venture company, which is staffed with a
significant number of managerial and financial
personnel seconded by the joint venturers, acts as
the general headquarters for the joint venture, responsible for the overall management of the project including coordination of the functions
separately performed by the individual joint
venturers on behalf of the joint venture company,
the investment of working capital contributed by
the joint venturers and the financing of the
project's additional capital requirements through
public and private borrowings. The joint venture
company derives portfolio investment income from
U.S. sources. Is this income eligible for
benefits under the U.S.-Austrian treaty?
Analysis: If the joint venture corporations's activities
constitute an active business and the income is
connected to that business, benefits would be
allowed under subparagraph 1(c). If not, it is
expected that the U.S. competent authority would
determine that treaty benefits should be allowed
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in accordance with paragraph 2 under the facts
presented, particularly in view of (i) the clear business purpose for the formation and location of the joint venture company; and (ii) the
significant headquarters functions performed by
that company in addition to financial functions.
The fact that all of the joint venturers are corporations resident in European Union member States having tax treaties in force with the United States and that they are engaged directly or through their affiliates in substantial active business
operations in such EU member states is an element in determining
eligibility for benefits under paragraph 2.
The discretionary authority granted to the competent author
ities in paragraph 2 is particularly important in view of the
developments in, and objectives of, international economic.
integration, such as that among the member states of the European
Union and the members of the North American Free Trade Agreement. It is expected that the authority will be exercised with particu
lar cognizance of those factors.
The Memorandum of Understanding notes that the United States
and Austria will discuss whether Article 16 should be amended to
reflect Austria's relationship with its EU partners. If such an
amendment proves to be desirable, a Protocol to the Convention
will be promptly negotiated to reflect this understanding.
Paragraph 4 addresses the so-called "triangular case," in
which an Austrian enterprise derives interest or royalty income
from the United States, and that income is attributable to a
permanent establishment located in a third jurisdiction, and that
third jurisdiction imposes little or no income tax liability on
those profits. This provision is necessary in this Convention to
prevent triangular case abuse since Austria exempts from tax
profits attributable to a permanent establishment of its resi
dents located in certain countries, although it would tax the
income (subject to a foreign tax credit) if the income were
earned directly by the Austrian resident and were not attribut
able to the permanent establishment in the third jurisdiction.
The Contracting States agreed that it would be inappropriate to
grant treaty benefits with respect to such income. Therefore,
paragraph 4 generally denies any treaty benefit with respect to
interest or royalty income beneficially owned by an Austrian
resident and attributable to a permanent establishment in a third
jurisdiction if the combined tax in Austria and the third juris
diction is less than 60 percent of the tax that would be imposed
in Austria if the income were subject to tax there. The para
graph is drafted for Austria only since it has no application
with respect to the United States, because the United States does
not exempt the profits of a U.S. company attributable to its
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foreign permanent establishments.
For example, assume that an Austrian Company has a permanent establishment in a third country and that the permanent establishment earns royalty income derived in the United States. The royalty income is attributable to the permanent establishment of the Austrian company in the third country. Also assume that, under the tax treaty in force between Austria and the third country, Austria will not impose its income tax on the profits of the Austrian company from its permanent establishment in the third country. Assume further that the royalty income received by the Austrian company will be subject to income tax in the third country at an effective rate of 22% (using a tax base comparable to that used in Austria). Inasmuch as 22% taxation in
the third country exceeds 60% of the tax that Austria would have
imposed (34%), the special disqualification provision of
paragraph 4 does not apply to that income.
The paragraph provides three exceptions to the general
restrictions. First, the provisions of paragraph 4 do not apply to interest derived in connection with or incidental to an active trade or business carried on by the permanent establishment in the third jurisdiction. The business of making or managing investments is not an active trade or business for this purpose
unless the activities are banking or insurance activities carried
on by a bank or insurance company. Second, they do not apply to
royalties received as compensation for the use of, or the right
to use, intangible property produced or developed by the perma nent establishment itself. Third, in the case of an Austrian
resident with a permanent establishment in a third jurisdiction,
the provisions of paragraph 4 do not apply if the profits of the
permanent establishment are taxed in the United States, ie.,
under the subpart F provisions of Part III of Subchapter N of
chapter 1 of subtitle A of the Internal Revenue Code.
Paragraph 5 provides additional authority to the competent
authorities (in addition to that of Article 25 (Mutual Agreement
Procedure)) to consult together to develop a common application
of the provisions of this Article. This provision is intended to
expedite matters relating to the factors relevant in making a
determination regarding qualification for treaty benefits.
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