Article 7. BUSINESS PROFITS

This Article provides rules **for** taxation **by** a Contracting

State of the business profits of an enterprise of the other

Contracting State. It updates the corresponding Article in the

1956 Convention to conform more closely to current U.S. treaty policy and to the OECD Model.

The general rule, found in paragraph **1,** is that business
'profits of an enterprise of one Contracting State may be taxed **by**

the other Contracting State only if the enterprise carries on business in that other Contracting State through a permanent establishment (as defined in Article 5 (Permanent Establishment))

situated there. Where that condition is met, the State in which

the permanent establishment is situated may tax only so much of

the income of the enterprise that is attributable to the perma­
nent establishment. This rule differs from the comparable rule

in the 1956 Convention, which contained a limited force of

attraction rule that permitted the State in which the permanent

establishment is located to tax income of the enterprise even if

not attributable to the permanent establishment, but only to the

extent that the income is derived from sources in that State.

Paragraph 2 provides rules for attributing business profits to a permanent establishment. The Contracting States will

attribute to a permanent establishment the profits that it would

have been expected to earn had it been a distinct and 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 regarding deductions for expenses incurred for the purposes of earning the income.

Paragraph 2 provides rules for attributing business profits to a permanent establishment. The Contracting States will

attribute to a permanent establishment the profits that it would

have been expected to earn had it been a distinct and 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 regarding deductions for expenses incurred for the purposes of earning the

The profits attributable to a permanent establishment may be from sources within or without a Contracting State. Thus, for

example, items of foreign source income described in section

864(c) (4) (B) of the Code may be attributed to a **U.S.** permanent

establishment of an Austrian enterprise and subject to tax in the United States. The concept of "attributable to" in the Conven­

tion is analogous to but narrower than the concept of "effective­

**ly** connected with" in section 864(c) of the Code. Thus, the
limited "force of attraction" rule of Code section 864(c) **(3)** is

not applicable under the Convention.

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Paragraph **3** provides that in determining the business

profits of a permanent establishment, deductions shall be allowed for a reasonable allocation of expenses incurred for the purposes

of the permanent establishment, regardless of where the expenses
are incurred. This rule ensures that business profits will be
taxed on a net basis. Among the expenses that may be incurred
for the purposes of the permanent establishment are expenses for
research and development, interest and other similar expenses, as
well as executive and general administrative expenses. The
paragraph specifies that the allocation of the enumerated expens­
es made in determining the profits attributable to the permanent
establishment must be "reasonable." This language allows the
United States to apply the types of expense allocations found in

U.S. law, for example, in Treasury Regulations sections 1.861-8 and 1.882-5.

This rule is not limited to expenses incurred exclusively for

the purposes of the permanent establishment, but includes
expenses incurred for the purposes of the enterprise as a whole,
or that part of the enterprise that includes the permanent
establishment. Deductions are to be allowed regardless of which
accounting unit of the enterprise books the expenses, so long as
they are incurred for the purposes of the permanent establish­
ment. Thus, a portion of the interest expense recorded on the
books of the home office in one State may be deducted **by** a

permanent establishment in the other (or vice versa) if properly allocable thereto.

Paragraph 4 provides that no business profits will be

attributed to a permanent establishment merely because it pur­

chases goods or merchandise for the enterprise of which it is a

permanent establishment. This rule refers to a permanent estab­
lishment 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 with
respect 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 states that, 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 and sufficient reason to change. In conformity
with current **U.S.** treaty policy and the **OECD** Model, the paragraph
applies "for the purposes of the preceding paragraphs."

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_Paragraph_ **_6_** explains the relationship between the _provisions_
of this Article and other provisions of the Convention. 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 this Arti­

cle. Thus, for example, the taxation of interest generally will

be determined by the rules of Article 11 (Interest), and not by

Article **7.** However, as provided in paragraph **3** of Article **11,** if
the interest is attributable to a permanent establishment, the
provisions of Article **7** apply instead.

Under this paragraph, income derived from shipping and air

transport activities that are described in Article **8** (Shipping
and Air Transport) is taxable only in the country of residence of

the enterprise regardless of whether it is attributable to a

permanent establishment situated in the source State. For

example, an airline ticket office situated in the United States' that constitutes a permanent establishment of an airline of

Austria will not be subject to tax in the United States with

respect to the profits attributable to that office, because such income is encompassed by Article 8.

Paragraph 7 specifies that the term "business profits" as used in the Convention includes income from the rental of tangi­

ble personal property. some countries subject this class of
income to gross basis taxation at source. The inclusion of this

class of income in business profits means that such income earned by a resident of a Contracting State can be taxed by the other

Contracting State only if the income is attributable to a perma­

nent establishment maintained **by** the resident in that other

State, and, if the income is taxable, it can be taxed only on a net basis.

Paragraph **8** contains a special rule relating to a particular

type of business entity, a sleeping partnership (Stille

Gesellschaft) under Austrian law. **A** sleeping partnership is not
a commercial partnership in the usual sense. It is a contract

concluded under commercial law by which an investor (the sleeping

partner) contributes money or money's worth to the business of

his contracting partner in exchange for a share in the profits of the business and under the entitlement to obtain specified

information about the development of the business. Commercial

law provides only one type of contract (with the possibility of

arranging bilaterally various details in different ways, egg,

the exclusion of participation in the losses, as long as the essential matters prescribed by law are observed). In relation to third parties (eg., customers, suppliers and other

contractors of the enterprise) only the owner of the business is

liable for the debts of the enterprise. Internally, it depends on the terms of the contract with the sleeping partner as to

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whether the sleeping partner participates only in profits or has also to bear a portion of the losses; but, even in the latter case, he is by law not obligated to increase his investment.

Under Austrian tax law, there are two kinds of sleeping

partnerships, the typical form and the non-typical form. In a
typical sleeping partnership, a partner whose interest is not
disclosed **(a** "sleeping partner") participates in (i) either the
profits and losses of the business, or (ii) only in its profits,

or (iii) in its profits up to a certain amount (and not in the
losses). However, in a typical sleeping partnership, a sleeping
partner does not participate in the capital and assets of the

business, and his rights upon withdrawal from the partnership are

limited to the return of his investment. Under Austrian tax law,

the profit of the sleeping partner in a typical sleeping partnership is within the category of income from investment activities.

In a non-typical sleeping partnership, a sleeping partner is entitled to participate in the increase in net wealth of the business property (that is, a certain portion of the business

value in case of termination of the contract) as well as in the
profits and losses of the business. The economic position of a

sleeping partner in a non-typical sleeping partnership is rather

close to that of a partner in **a** partnership; thus, the sleeping

partnership contract is subjected to the Austrian partnership taxation regime and the profit is considered to be income from commercial activities.

The taxation of the income of a sleeping partnership (both
the typical and the non-typical forms) under Austrian law is
illustrated **by** the following example. The **U.S.** corporation **(US)**

invests 10,000 under a sleeping partnership contract in the

Austrian company **(A).** **US** is granted a **10%** share in the profits
of **A.** In year 1 **A** makes a profit (before taxes and before

deduction of the sleeping partner's share) of 20,000. In year 2, after the finalization of the financial statements for year 1, US receives a cash payment of 2,000.

Under Austrian domestic law, Austria's taxation of the

typical sleeping partnership _is_ _as_ follows: In year **_2,_** **A** must

withhold 25% of 2,000 (which is 500). In year 3, US must file a

corporation tax return in Austria for year **1.** Assume that the

net income of US from its Austrian investment (e.g. after

deduction of refinancing cost, travel expenditure, etc.) is

**1,000.** **US** will receive an assessment notice (probably also in

year 3) according to which the tax liability for year 2 is

determined to be 340. The **500** previously withheld is credited
against that tax liability so that, at the end, **US** has a claim
for refund of **160** against the Austrian government. The taxable

income of A is 18,000 (in year 1) because A's income is reduced

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by the 2,000 distributed to US.

Under Austrian domestic law, Austria's taxation of the nontypical sleeping partnership is as follows: Under the partnership regime, the joint income of A and US is determined

for year **1** to be 20,000. The portion of 2,000 which belongs to
**_US_** is reduced (in the declaration for the joint profit
determination) **by** special expenses incurred **by** the partner. So
again the taxable profit of **US** for year **1** is **1,000.** The tax
liability **of** **US** for year **1** is 340. **US** has to settle that tax

liability by making a cash payment to the Austrian tax

administration of 340. **If,** in year 2, an amount of 2,000 is

transferred into the hands of US, then this is seen as a withdrawal of property and does not constitute a taxable event.

No tax withholding applies. The taxable income of **A** is **18,000**
(in year **1)** because A's income is reduced **by** the 2,000 allocated

to US.

In specific cases, it may be unclear as to the whether a sleeping partnership should be categorized as the typical or the

non-typical form. In order to avoid this classification issue

under the convention, paragraph 8 applies to income from both forms; thus, the income derived by a U.S. sleeping partner with

respect to his interest in a sleeping partnership, whether

typical or non-typical, is considered business profits under the Convention and subject to tax in Austria to the extent attribut­

able to a permanent establishment in Austria. Under paragraph **8,**
if the activities carried on **by** the sleeping partnership

constitute a permanent establishment in Austria, the permanent establishment of the partnership is attributed to a U.S. sleeping partner.

Paragraph 9 elaborates on paragraphs 1 and 2 of Article 7, and on the rules in a number of other articles of the Convention

that relate to permanent establishment's and fixed bases. These

are paragraph 4 of Article 10 (Dividends), paragraph 3 of Article

**11** (Interest), paragraph 4 of Article 12 (Royalties), paragraph **3**
**of** Article **13** (Capital Gains), Article 14 (Independent Personal

Services) and paragraph 2 of Article 21 (Other Income). Para­

graph **9** incorporates the rule of Code section. 864(c) **(6)** into the
Convention. It provides that any income or gain attributable to

a permanent establishment (or, in the context of the other arti­

cles, a fixed base as well) during its existence is taxable in

the Contracting State where the permanent establishment (or fixed

base) is or was situated even if the payments are deferred until
after the permanent establishment (or fixed base) no longer
exists.

The effect of this rule can be illustrated **by** the following
example. Assume a company that is a resident of Austria and that

maintains a permanent establishment in the United States winds up

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the permanent establishment's affairs and sells the permanent establishment's inventory and assets to a U.S. buyer at the end of year 1, in exchange for an interest-bearing installment obligation payable in full by the end of year 3. Despite the

fact that Article 13's threshold requirement for **U.S.** taxation is
not met in years 2 or **3,** because the company has no permanent
establishment in the United States, the United States may tax the
deferred income payment received **by** the company with respect to
the installment obligation in year 2 and year **3** under Article **7**

(pursuant to the application of paragraph **3** of Article **11**
(Interest)).

This Article is subject to the saving clause of paragraph 4 of Article 1 (Personal Scope). Thus, for example, if a citizen of the United States who is a resident of Austria derives busi­ ness 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
2 of Article 22 (Relief from Double Taxation), tax those profits
as part of the worldwide income of the citizen, notwithstanding

the provisions of this Article under which such income derived by a resident of Austria is exempt from U.S. tax. The business profits are also subject to the provisions of Article 16 (Limita­ tion on Benefits). For example, assume an Austrian company is doing business in the United States and is earning income effec­ tively connected with a trade or business in the United States, but does not have a permanent establishment in the United States. Under the provisions of Article 7, that company would not be subject to U.S. tax on its business profits. If, however, the company does not qualify for U.S. benefits under Article 16, its

income that is effectively connected with its **U.S.** trade or
business would be subject to **U.S.** tax.

Article 8. SHIPPING AND AIR TRANSPORT

This Article provides rules governing the taxation of profits from the operation of ships and aircraft in international traffic. The term "international traffic" is defined in subpara­ graph 1(d) of Article 3 (General Definitions) as any transport by a ship or aircraft, except where such transport is solely between places in the other Contracting State. Paragraph 1 provides that profits of an enterprise of a Contracting State from operating ships or aircraft in interna­ tional traffic shall be taxable only in that Contracting State. This rule is the same as the rule under the 1956 Convention. By virtue of paragraph 6 of Article 7 (Business Profits), profits of an enterprise of a Contracting State that are exempt in the other Contracting State under this paragraph remain exempt even if the enterprise has a permanent establishment in that other Contract

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ing State.

Paragraph 2 extends the definition of profits from the
operation of ships or aircraft in international traffic to

include profits from the rental of ships or aircraft on a full

(i~e., equipped with crew and supplies) basis <sup>or</sup> <sup>on a</sup> <sup>bareboat</sup>
(i.e., without crew and supplies) basis if the ships or aircraft

are operated in international traffic by the lessee, or if the rental profits are incidental to profits from the operation of ships or aircraft in international traffic (as described in paragraph 1).

It is understood, consistent with the Commentary to Article 8 of the OECD Model, that income earned by an enterprise from the inland transport of property or passengers within either con­ tracting State falls within Article 8 if the transport is under­ taken as part of the international transport of property or

passengers **by** the enterprise. Thus, if a **U.S.** shipping company

contracts to carry property from Austria to a U.S. city and, as part of that contract, it transports the property by truck from its point of origin to an airport in Austria (or it contracts

with a trucking company to carry the property to the airport) the

income earned by the U.S. shipping company from the overland leg of the journey would be taxable only in the United States.

In addition, certain non-transport activities that are an

integral part of the services performed **by** a transport company
are understood, consistent with the Commentary to Article **8** of

the OECD Model, to be covered in paragraph 1, though they are not

specified in paragraph 2. These include, for example, the

performance of some maintenance or catering services by one airline for another airline, if these services are incidental to the -provision of those services by the airline for itself.

Income earned **by** concessionaires, however, is not covered **by**

Article 8. Paragraph 3 provides that the profits of an enterprise of a Contracting State from the use, rental, or maintenance of con­

tainers (including equipment for their transport) used to trans­

port goods in international traffic will be exempt from tax in

the other Contracting State. This rule applies regardless of

whether the recipient of the income is engaged in the operation of ships or aircraft in international traffic, and regardless of whether the enterprise has a permanent establishment in the other

Contracting State. Paragraph **3** applies to an enterprise of a

Contracting State regardless of the form of the enterprise. Thus, it applies to a partnership or other pass-through entity to the extent the entity is an enterprise of a Contracting State under the Convention.

The shipping and air transport provisions of the 1956

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Convention do not deal with income from the leasing of ships or aircraft, except when such leasing is an occasional source of income for an enterprise engaged in the international operation of ships or aircraft. Also, the 1956 Convention does not deal with income from the use, rental, or maintenance of containers except when such container income is supplementary or incidental to its international operation of ships or aircraft.

Paragraph 4 clarifies that the provisions of the preceding paragraphs apply equally to profits derived by an enterprise of a Contracting State from participation in a pool, joint business,

or international operating agency. Therefore, the clarification
under paragraph 4 extends to profits from the participation **by**

the pool in the lease of containers which is supplementary or incidental to its international operation of ships or aircraft.

The taxation of gains from the alienation of ships, aircraft or containers is not dealt with in this Article, but in paragraph

**5** of Article **13** (Capital Gains).

This Article is subject to the saving clause of paragraph 4 of Article 1 (Personal Scope). The United States, therefore, may, subject to the special foreign tax credit rules of paragraph 2 of Article 22 (Relief from Double Taxation), tax the shipping or air transport profits of a resident of Austria if that Austrian resident is a citizen of the United States. As with any benefit of the Convention, the enterprise claiming the benefit must be entitled to the benefit under the provisions of Article 16 (Limitation on Benefits).