EXPLANATION OF PROPOSED INCOME TAX TREATY BETWEEN 

THE UNITED STATES AND ICELAND 

Scheduled for a Hearing 

Before the 

COMMITTEE ON FOREIGN RELATIONS 

UNITED STATES SENATE 

On July 10, 2008 

____________ 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

July 8, 2008 

JCX-58-08 
 

i

CONTENTS 

Page

INTRODUCTION .......................................................................................................................... 1 

I. SUMMARY........................................................................................................................ 2 

II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE AND 

INVESTMENT AND U.S. TAX TREATIES .................................................................... 4 

A. U.S. Tax Rules .............................................................................................................. 4 

B. U.S. Tax Treaties .......................................................................................................... 6

III. OVERVIEW OF TAXATION IN ICELAND.................................................................... 8 

A. National Income Taxes ................................................................................................. 8 

B. International Aspects of Taxation in Iceland.............................................................. 11 

C. Other Taxes................................................................................................................. 13 

IV. THE UNITED STATES AND ICELAND: CROSS-BORDER INVESTMENT AND 

TRADE ............................................................................................................................. 14 

A. Introduction................................................................................................................. 14 

B. Overview of International Transactions Between the United States and Iceland....... 15 

C. Analyzing the Economic Effects of Income Tax Treaties.......................................... 17 

V. EXPLANATION OF PROPOSED TREATY AND PROTOCOL. ................................. 18 

Article 1. General Scope................................................................................................... 18 

Article 2. Taxes Covered ................................................................................................. 21 

Article 3. General Definitions.......................................................................................... 21 

Article 4. Resident ........................................................................................................... 23 

Article 5. Permanent Establishment................................................................................. 25 

Article 6. Income from Immovable Property (Real Property)......................................... 26 

Article 7. Business Profits................................................................................................ 27 

Article 8. Shipping and Air Transport ............................................................................. 32 

Article 9. Associated Enterprises..................................................................................... 34 

Article 10. Dividends....................................................................................................... 35

Article 11. Interest ........................................................................................................... 39 

Article 12. Royalties ........................................................................................................ 42 

Article 13. Capital Gains.................................................................................................. 43 

Article 14. Income from Employment............................................................................. 45 

Article 15. Directors’ Fees............................................................................................... 46 

Article 16. Entertainers and Sportsmen ........................................................................... 46 

Article 17. Pensions, Social Security, and Annuities....................................................... 48 

Article 18. Government Service ...................................................................................... 50 

Article 19. Students and Trainees .................................................................................... 51 
 

ii

Article 20. Other Income ................................................................................................. 52 

Article 21. Limitation on Benefits ................................................................................... 53 

Article 22. Relief From Double Taxation........................................................................ 61 

Article 23. Non-Discrimination ....................................................................................... 65 

Article 24. Mutual Agreement Procedure........................................................................ 66 

Article 25. Exchange of Information and Administrative Assistance ............................. 68 

Article 26. Members of Diplomatic Missions and Consular Posts.................................. 71 

Article 27. Entry into Force ............................................................................................. 71 

Article 28. Termination.................................................................................................... 72 

VI. DISCUSSION................................................................................................................... 73 

A. Students and Trainees ................................................................................................. 73 

B. Limitation on Benefits ................................................................................................ 75 
 

1

INTRODUCTION 

This pamphlet,1

 prepared by the staff of the Joint Committee on Taxation, describes the 

proposed income tax treaty between the United States and Iceland as supplemented by a 

protocol. The provisions of the protocol, by its terms, form an integral part of the proposed 

treaty. Unless otherwise specified, the proposed treaty and the protocol are hereinafter referred 

to collectively as the “proposed treaty.” The proposed treaty was signed on October 23, 2007. 

The Senate Committee on Foreign Relations (the “Committee”) has scheduled a public hearing 

on the proposed treaty for July 10, 2008.2

Part I of the pamphlet provides a summary of the proposed treaty. Part II provides a brief 

overview of U.S. tax laws relating to international trade and investment and of U.S. income tax 

treaties in general. Part III contains a brief overview of Icelandic tax laws. Part IV provides a 

discussion of investment and trade flows between the United States and Iceland. Part V contains 

an article-by-article explanation of the proposed treaty. Part VI contains a discussion of issues 

relating to the proposed treaty. 

 1

 This pamphlet may be cited as follows: Joint Committee on Taxation, Explanation of Proposed 

Income Tax Treaty Between the United States and Iceland (JCX-58-08), July 8, 2008. References to “the 

Code” are to the U.S. Internal Revenue Code of 1986, as amended. This document is available on the 

internet at www.jct.gov. 

2

 For a copy of the proposed treaty, see Senate Treaty Doc. 110-17. 
 

2

I. SUMMARY 

The principal purposes of the proposed treaty are to reduce or eliminate double taxation 

of income earned by residents of either country from sources within the other country and to 

prevent avoidance or evasion of the taxes of the two countries. The proposed treaty also is 

intended to promote close economic cooperation between the two countries and to eliminate 

possible barriers to trade and investment caused by overlapping taxing jurisdictions of the two 

countries. As in other U.S. tax treaties, these objectives principally are achieved through each 

country’s agreement to limit, in certain specified situations, its right to tax income derived from 

its territory by residents of the other country. 

For example, the proposed treaty contains provisions under which each country generally 

agrees not to tax business income derived from sources within that country by residents of the 

other country unless the business activities in the taxing country are substantial enough to 

constitute a permanent establishment (Article 7). Similarly, the proposed treaty contains certain 

exemptions under which residents of one country performing personal services in the other 

country will not be required to pay tax in the other country unless their contact with the other 

country exceeds specified minimums (Articles 14 and 16). The proposed treaty also provides 

that pensions and other similar remuneration paid to a resident of one country may be taxed only 

by that country, and only at such time and to the extent that a pension distribution is made 

(Article 17). 

The proposed treaty provides that dividends and certain gains derived by a resident of 

either country from sources within the other country generally may be taxed by both countries 

(Articles 10 and 13); however, the rate of tax that the source country may impose on a resident of 

the other country on dividends may be limited by the proposed treaty. The proposed treaty 

provides that, subject to certain rules and exceptions, interest and most types of royalties derived 

by a resident of either country from sources within the other country may be taxed only by the 

residence country (Articles 11 and 12). Notwithstanding this general rule, the source country 

may impose tax on certain royalties in an amount not to exceed five percent of such royalties. 

In situations in which the country of source retains the right under the proposed treaty to 

tax income derived by residents of the other country, the proposed treaty generally provides for 

relief from the potential double taxation through the allowance by the country of residence of a 

tax credit for certain foreign taxes paid to the other country (Article 22). 

The proposed treaty contains the standard provision (the “saving clause”) included in 

U.S. tax treaties pursuant to which each country retains the right to tax its residents and citizens 

as if the treaty had not come into effect (Article 1). In addition, the proposed treaty contains the 

standard provision providing that the treaty may not be applied to deny any taxpayer any benefits 

to which the taxpayer would be entitled under the domestic law of a country or under any other 

agreement between the two countries (Article 1). 

The proposed treaty (Article 19) generally provides that students, business trainees, and 

researchers visiting the other treaty country are exempt from host country taxation on certain 

types of payments received. 
 

3

The proposed treaty provides authority for the two countries to resolve disputes (Article 

24) and exchange information (Article 25) in order to carry out the provisions of the proposed 

treaty. 

The proposed treaty also contains a detailed limitation-on-benefits provision that reflects 

the anti-treaty-shopping provisions included in the United States Model Income Tax Convention 

of November 15, 2006 (“U.S. Model treaty”) and more recent U.S. income tax treaties. The new 

rules are intended to prevent the inappropriate use of the treaty by third-country residents 

(Article 21). 

The provisions of the proposed treaty will have effect generally on or after the first day of 

January following the date that the proposed treaty enters into force. The proposed treaty allows 

taxpayers to temporarily continue to claim benefits under the present treaty for up to an 

additional year if they would have been entitled to greater benefits under the present treaty. In 

addition, a teacher entitled to benefits under the present treaty at the time the proposed treaty 

enters into force will continue to be entitled to the benefits available under the present treaty for 

as long as such individual would have been entitled to the previously existing benefits. 

The proposed treaty replaces the existing treaty (signed in 1975). The rules of the 

proposed treaty generally are similar to rules of recent U.S. income tax treaties, the U.S Model 

treaty,3

 and the 2005 Model Convention on Income and on Capital of the Organisation for 

Economic Cooperation and Development (“OECD Model treaty”). However, the proposed 

treaty contains certain substantive deviations from these treaties and models. These deviations 

are noted throughout the explanation of the proposed treaty in Part V of this pamphlet. 

 3

 For a comparison of the U.S. Model treaty with its 1996 predecessor, see Joint Committee on 

Taxation, Comparison of the United States Model Income Tax Convention of September 20, 1996 with the 

United States Model Income Tax Convention of November 15, 2006 (JCX-27-07), May 8, 2007. 
 

4

II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE 

AND INVESTMENT AND U.S. TAX TREATIES 

This overview briefly describes certain U.S. tax rules relating to foreign income and 

foreign persons that apply in the absence of a U.S. tax treaty. This overview also discusses the 

general objectives of U.S. tax treaties and describes some of the modifications to U.S. tax rules 

made by treaties. 

A. U.S. Tax Rules 

The United States taxes U.S. citizens, residents, and corporations on their worldwide 

income, whether derived in the United States or abroad. The United States generally taxes 

nonresident alien individuals and foreign corporations on all their income that is effectively 

connected with the conduct of a trade or business in the United States (sometimes referred to as 

“effectively connected income”). The United States also taxes nonresident alien individuals and 

foreign corporations on certain U.S.-source income that is not effectively connected with a U.S. 

trade or business. 

Income of a nonresident alien individual or foreign corporation that is effectively 

connected with the conduct of a trade or business in the United States generally is subject to U.S. 

tax in the same manner and at the same rates as income of a U.S. person. Deductions are 

allowed to the extent that they are related to effectively connected income. A foreign 

corporation also is subject to a flat 30-percent branch profits tax on its “dividend equivalent 

amount,” which is a measure of the effectively connected earnings and profits of the corporation 

that are removed in any year from the conduct of its U.S. trade or business. In addition, a foreign 

corporation is subject to a flat 30-percent branch-level excess interest tax on the excess of the 

amount of interest that is deducted by the foreign corporation in computing its effectively 

connected income over the amount of interest that is paid by its U.S. trade or business. 

U.S.-source fixed or determinable annual or periodical income of a nonresident alien 

individual or foreign corporation (including, for example, interest, dividends, rents, royalties, 

salaries, and annuities) that is not effectively connected with the conduct of a U.S. trade or 

business is subject to U.S. tax at a rate of 30 percent of the gross amount paid. Certain insurance 

premiums earned by a nonresident alien individual or foreign corporation are subject to U.S. tax 

at a rate of one or four percent of the premiums. These taxes generally are collected by means of 

withholding. 

Specific statutory exemptions from the 30-percent withholding tax are provided. For 

example, certain original issue discount and certain interest on deposits with banks or savings 

institutions are exempt from the 30-percent withholding tax. An exemption also is provided for 

certain interest paid on portfolio debt obligations. In addition, income of a foreign government 

or international organization from investments in U.S. securities is exempt from U.S. tax. 

U.S.-source capital gains of a nonresident alien individual or a foreign corporation that 

are not effectively connected with a U.S. trade or business generally are exempt from U.S. tax, 

with two exceptions: (1) gains realized by a nonresident alien individual who is present in the 
 

5

United States for at least 183 days during the taxable year, and (2) certain gains from the 

disposition of interests in U.S. real property. 

Rules are provided for the determination of the source of income. For example, interest 

and dividends paid by a U.S. citizen or resident or by a U.S. corporation generally are considered 

U.S.-source income. Conversely, dividends and interest paid by a foreign corporation generally 

are treated as foreign-source income. Special rules apply to treat as foreign-source income (in 

whole or in part) interest paid by certain U.S. corporations with foreign businesses and to treat as 

U.S.-source income (in whole or in part) dividends paid by certain foreign corporations with U.S. 

businesses. Rents and royalties paid for the use of property in the United States are considered 

U.S.-source income. 

Because the United States taxes U.S. citizens, residents, and corporations on their 

worldwide income, double taxation of income can arise when income earned abroad by a U.S. 

person is taxed by the country in which the income is earned and also by the United States. The 

United States seeks to mitigate this double taxation generally by allowing U.S. persons to credit 

foreign income taxes paid against the U.S. tax imposed on their foreign-source income. A 

fundamental premise of the foreign tax credit is that it may not offset the U.S. tax liability on 

U.S.-source income. Therefore, the foreign tax credit provisions contain a limitation that ensures 

that the foreign tax credit offsets only the U.S. tax on foreign-source income. The foreign tax 

credit limitation generally is computed on a worldwide basis (as opposed to a “per-country” 

basis). The limitation is applied separately for certain classifications of income. In addition, 

special limitations apply to credits for foreign taxes imposed on foreign oil and gas extraction 

income and foreign oil related income. 

For foreign tax credit purposes, a U.S. corporation that owns 10 percent or more of the 

voting stock of a foreign corporation and receives a dividend from the foreign corporation (or is 

otherwise required to include in its income earnings of the foreign corporation) is deemed to 

have paid a portion of the foreign income taxes paid by the foreign corporation on its 

accumulated earnings. The taxes deemed paid by the U.S. corporation are included in its total 

foreign taxes paid and its foreign tax credit limitation calculations for the year in which the 

dividend is received. 
 

6

B. U.S. Tax Treaties 

The traditional objectives of U.S. tax treaties have been the avoidance of international 

double taxation and the prevention of tax avoidance and evasion. Another related objective of 

U.S. tax treaties is the removal of the barriers to trade, capital flows, and commercial travel that 

may be caused by overlapping tax jurisdictions and by the burdens of complying with the tax 

laws of a jurisdiction when a person’s contacts with, and income derived from, that jurisdiction 

are minimal. To a large extent, the treaty provisions designed to carry out these objectives 

supplement U.S. tax law provisions having the same objectives; treaty provisions modify the 

generally applicable statutory rules with provisions that take into account the particular tax 

system of the treaty partner. 

The objective of limiting double taxation generally is accomplished in treaties through 

the agreement of each country to limit, in specified situations, its right to tax income earned from 

its territory by residents of the other country. For the most part, the various rate reductions and 

exemptions agreed to by the source country in treaties are premised on the assumption that the 

country of residence will tax the income at levels comparable to those imposed by the source 

country on its residents. Treaties also provide for the elimination of double taxation by requiring 

the residence country to allow a credit for taxes that the source country retains the right to 

impose under the treaty. In addition, in the case of certain types of income, treaties may provide 

for exemption by the residence country of income taxed by the source country. 

Treaties define the term “resident” so that an individual or corporation generally will not 

be subject to tax as a resident by both of the countries. Treaties generally provide that neither 

country will tax business income derived by residents of the other country unless the business 

activities in the taxing jurisdiction are substantial enough to constitute a permanent establishment 

or fixed base in that jurisdiction. Treaties also contain commercial visitation exemptions under 

which individual residents of one country performing personal services in the other will not be 

required to pay tax in that other country unless their contacts exceed certain specified minimums 

(e.g., presence for a set number of days or earnings in excess of a specified amount). Treaties 

address passive income such as dividends, interest, and royalties from sources within one 

country derived by residents of the other country either by providing that such income is taxed 

only in the recipient’s country of residence or by reducing the rate of the source country’s 

withholding tax imposed on such income. In this regard, the United States agrees in its tax 

treaties to reduce its 30-percent withholding tax (or, in the case of some income, to eliminate it 

entirely) in return for reciprocal treatment by its treaty partner. 

In its treaties, the United States, as a matter of policy, generally retains the right to tax its 

citizens and residents on their worldwide income as if the treaty had not come into effect. The 

United States also provides in its treaties that it will allow a credit against U.S. tax for income 

taxes paid to the treaty partners, subject to the various limitations of U.S. law. 

The objective of preventing tax avoidance and evasion generally is accomplished in 

treaties by the agreement of each country to exchange tax-related information. Treaties generally 

provide for the exchange of information between the tax authorities of the two countries when 

such information is necessary for carrying out provisions of the treaty or of their domestic tax 

laws. The obligation to exchange information under the treaties typically does not require either 
 

7

country to carry out measures contrary to its laws or administrative practices or to supply 

information that is not obtainable under its laws or in the normal course of its administration or 

that would reveal trade secrets or other information the disclosure of which would be contrary to 

public policy. The Internal Revenue Service (the “IRS”) and the treaty partner’s tax authorities 

can request specific tax information from a treaty partner. This can include information to be 

used in a criminal investigation or prosecution. 

Administrative cooperation between countries is enhanced further under treaties by the 

inclusion of a “competent authority” mechanism to resolve double taxation problems arising in 

individual cases and, more generally, to facilitate consultation between tax officials of the two 

governments. 

Treaties generally provide that neither country may subject nationals of the other country 

(or permanent establishments of enterprises of the other country) to taxation more burdensome 

than the tax it imposes on its own nationals (or on its own enterprises). Similarly, in general, 

neither treaty country may discriminate against enterprises owned by residents of the other 

country. 

At times, residents of countries that do not have income tax treaties with the United 

States attempt to use a treaty between the United States and another country to avoid U.S. tax. 

To prevent third-country residents from obtaining treaty benefits intended for treaty country 

residents only, treaties generally contain an “anti-treaty-shopping” provision that is designed to 

limit treaty benefits to bona fide residents of the two countries. 
 

8

III. OVERVIEW OF TAXATION IN ICELAND4

A. National Income Taxes 

Overview

Iceland imposes income tax on income at the national level. Taxable income is computed 

on an annual basis and is taxed either by assessment or by a final withholding tax. For 

individuals, the rates of tax and deductions allowed depend on the type of income earned. Since 

1999, Iceland has had a classical corporate taxation system, and companies generally may deduct 

dividends received from resident and nonresident companies. Individual shareholders receive a 

reduced tax rate on dividends. Under recently enacted legislation, if certain requirements are 

satisfied, no tax is imposed on capital gain from an individual’s or a corporation’s sale of stock 

in a company. 

Individuals

Individuals resident in Iceland are taxed on their worldwide income.5

 Sources of taxable 

income include income from three categories: (1) wages, salaries, benefits, pensions, social 

security payments, grants, royalties, and payments to copyright holders, (2) business and 

independent economic activity income, and (3) investment income (e.g., dividends, interest, and 

capital gains).6

 Operating losses may be deducted only from income in the second category. For 

individuals engaged in a business, the three categories of income are aggregated and taxed at 

normal rates. For individuals not engaged in business, the income in the first and second 

categories is aggregated and taxed at a rate of 22.75 percent, while the income in the third 

category is taxed at a flat 10-percent rate. Tax on employment income, including pensions and 

benefits-in-kind, is withheld by the employer on a monthly basis.7 Expenses related to acquiring 

investment income are not deductible.8

 In general, taxes withheld on investment income are 

creditable. Royalty payments are not considered investment income, and related expenses are 

deductible. The taxation of capital gains depends on the type of property sold; gains from the 

 4

 The information in this section relates to foreign law and is based on the Joint Committee 

staff’s review of publicly available secondary sources, including in large part G. Valdimarsson, 

International Bureau of Fiscal Documentation European Taxation, Iceland (“IBFD Iceland, Country 

Survey”), available at http://checkpoint.riag.com. The description is intended to serve as a general 

overview; it may not be fully accurate in all respects, as many details have been omitted and simplifying 

generalizations made for ease of exposition. The quoted tax rates and threshold amounts apply in 2008. 

U.S. dollar equivalents were calculated using the currency rate for January 1, 2008, according to 

OANDA’s FX Converter, available at http://www.oanda.com. 

5

 IBFD Iceland, Country Survey B.1.2.1. 

6

 IBFD Iceland, Country Survey B.1.2.1. 

7

 IBFD Iceland, Country Survey B.1.9.2. 

8

 IBFD Iceland, Country Survey B.1.5. 
 

9

sale of privately owned moveable property are not taxed, unlike gains from the sale of privately 

owned shares, gains from the sale of certain private residences, gains from the sale of 

nonbusiness immoveable property, and gains from the sale of property derived in the course of a 

business. From the beginning of 2008, capital gains on the income from sales of shares generally 

have been abolished.9

In 2008 and later years, the national income tax rate on aggregate income is 22.75 

percent.10 There is also a municipal tax of 12.97 percent collected by withholding. In total, the 

withholding taxes in Iceland are 35.72 percent.11

Tax relief is provided in the form of several deductions and allowances. For example, an 

individual’s four-percent pension insurance premium is deductible from employment income. 

Child benefits are granted for every child subject to income thresholds.12 A personal exemption 

of ISK 408,409 ($6,546) is deducted from the calculated tax. An unused tax credit is 

transferable between spouses.13 There is also a fisherman’s exemption of ISK 874 ($14) per 

day.14

Corporations 

Corporations resident in Iceland are subject to a corporate tax on their worldwide 

income.15 A legal entity is a resident of Iceland if it is registered in Iceland, if its articles of 

incorporation provide that its home is in Iceland, or if its effective place of management is 

Iceland.16 Resident entities subject to the corporate tax include registered corporate entities 

where participators are not personally liable for the entities’ debts; commercial banks and 

lending institutions; mutual insurance associations and cooperative societies; general, limited, 

and limited liability partnerships registered as taxable entities; registered public and private 

companies; marketing and production organizations; and other entities that carry on a business. 

 9

 Worldwide Tax Daily, 2008 WTD 107-3. 

10 IBFD Iceland, Country Survey B.1.9.1. 

11 Internal Revenue Directorate, http://rsk.is/international/en and Nordisk eTax, 

http://www.nordisketax.net/main.asp?url=/hem.asp&c=isl&l=eng&s=1&w=3&m=02. 

12 Principal Tax Rates 2008, Icelandic Ministry of Finance, 

http://eng.fjarmalaraduneyti.is/customs-and-taxes/principaltaxrates/nr/10062. 

13 Principal Tax Rates 2008, Icelandic Ministry of Finance, 

http://eng.fjarmalaraduneyti.is/customs-and-taxes/principaltaxrates/nr/10062. 

14 Id. 

15 IBFD Iceland, Country Survey A.1.3.1. 

16 IBFD Iceland, Country Survey A.1.2.1. 
 

10

The standard corporate tax rate is 18 percent. This rate also generally applies to limited 

liability companies. A 26-percent rate applies to partnerships registered as taxable entities.17 

Under legislation recently passed by the Icelandic Parliament, the partnership tax rate is reduced 

to 23.5 percent, and the limited liability company rate is reduced to 15 percent.18 Capital gains 

derived by resident entities are generally aggregated with all other income for taxation at the 

corporate rate. Capital losses are generally not deductible but may offset gains from the sale in 

the same year of similar assets. Under the recent legislation, a corporation generally is exempt 

from tax on capital gain from the sale of shares in resident and nonresident companies if, in the 

case of a nonresident company, the company is subject to taxation similar to the taxation of 

Icelandic companies and at a rate at least as high as the rate generally applicable in OECD 

member countries or European Economic Area member states.19 Net operating loss carrybacks 

are not permitted, but losses may be carried forward 10 years.20

The taxation of dividends depends on the type of recipient. Dividends paid by a resident 

company to a resident corporate shareholder are subject to a 10-percent withholding tax and may 

be deducted by the recipient. Dividends paid to a resident individual shareholder are taxed at a 

reduced rate.21 Resident companies generally may deduct dividends received from both resident 

and nonresident companies. 

 17 IBFD Iceland, Country Survey A.1.6.1. 

18 Deloitte, International Tax, Iceland Tax Alert, June 2, 2008, 

http://www.deloitte.com/dtt/cda/doc/content/dtt_tax_alert_iceland_060208.pdf. 

19 Id. 

20 IBFD Iceland, Country Survey A.1.5.1. and 2. 

21 IBFD Iceland, Country Survey A.1.1 and A.1.6.2. 
 

11

B. International Aspects of Taxation in Iceland 

Individuals

Individuals resident in Iceland are taxed on their worldwide income.22 An individual is 

considered a resident of Iceland if he stays in Iceland for six months or longer.23 Nonresident 

individuals are taxed only on their Icelandic-source income and capital gains.24 A 15-percent 

assessment is imposed on Icelandic-source salaries, wages, grants, director and committee 

member income, independent personal service income, and art performance income.25 Iceland 

requires a withholding tax on dividends paid by resident companies to nonresident individuals at 

a rate of 10 percent.26 Icelandic-source interest derived by nonresidents is tax exempt. Royalty 

income arising from Icelandic sources is subject to a 35.72-percent final withholding tax. 

Icelandic-source business income derived by nonresidents is taxed the same as if derived by a 

resident. A 10-percent tax is assessed on nonresident individuals on gains from the sale or lease 

of property located in Iceland. 

Corporations

Companies resident in Iceland are generally taxed on their worldwide income. A foreign 

company is subject to the Icelandic corporate tax on income derived through the carrying on of, 

participation in, or entitlement to a share of profits of a business through a permanent 

establishment in Iceland. 

Nonresidents are taxed on capital gains realized on property located Iceland and 

intangibles pertaining to an Icelandic permanent establishment. Under recently-enacted 

legislation, nonresident companies are exempt from taxes on capital gains from the sale of 

Icelandic company shares. Icelandic-source interest paid to nonresidents is not subject to 

withholding tax. Royalty payments made to nonresident companies are subject to tax on their 

net amount. Because the royalties are subject to withholding tax at the general corporate rate, 

any tax withheld is credited against the final tax liability. 

The Icelandic Parliament approved an amendment to the Income Tax Act on May 30,

2008 to reduce withholding taxes on dividends paid to nonresident companies.27 The new 

withholding tax rate, 10 percent, is the same as the rate applicable to dividends paid to resident 

 22 IBFD Iceland, Country Survey B.1.2.1. 

23 IBFD Iceland, Country Survey B.1.1. 

24 IBFD Iceland, Country Survey B.6.3.1. 

25 IBFD Iceland, Country Survey B.6.3.1. 

26 IBFD Iceland, Country Survey B.6.3.1. 

27 Worldwide Tax Daily, 2008 WTD 107-3. 
 

12

companies.28 Under the legislation, tax on dividends paid to companies within the European 

Economic Area is abolished.29

Relief from double taxation

In the absence of a treaty, relief from double taxation of foreign source income generally 

is provided in the form of a tax credit. 

 28 Deloitte, International Tax, Iceland Tax Alert, June 2, 2008, 

http://www.deloitte.com/dtt/cda/doc/content/dtt_tax_alert_iceland_060208.pdf. 

29 Id.
 

13

C. Other Taxes 

Inheritance, gift, and wealth taxes

Iceland imposes a five-percent inheritance tax where the decedent was an Icelandic 

resident at the time of death. Each beneficiary is permitted an ISK 1 million ($16,026) 

exemption. Inheritances received by spouses and cohabitants are fully exempt. Iceland has no 

gift tax; however, gifts are included in taxable income. Certain gifts may be exempt from tax if 

they are of value considered normal under the circumstances. Iceland does not impose a wealth 

tax.30

Social security

Social security contributions are paid by employers and self-employed individuals in 

Iceland. In addition, all employees must pay a deductible four percent pension insurance 

premium into a public pension fund. 

A flat tax rate of ISK 7,103 ($114) per year is levied for the Construction Fund for the 

Elderly, a central government fund that finances the construction and operation of nursing homes 

and senior care centers. Individuals under the age of 16 and over the age of 69 are exempt from 

this tax, as are those with incomes below ISK 1,080,067 ($17,313) in 2008.31

Other indirect taxes

Iceland imposes a value added tax (VAT) on the consumption of goods and services. The 

standard VAT rate is 24.5 percent, but the rate is reduced for certain products and services,32 and 

some products and services are exempt from VAT. Stamp duties are levied on a number of 

documents. 

 30 IBFD Iceland, Country Survey B.5. 

31 Principal Tax Rates 2008, Icelandic Ministry of Finance, 

http://eng.fjarmalaraduneyti.is/customs-and-taxes/principaltaxrates/nr/10062. 

32 IBFD Iceland, Country Survey A.8.6. 
 

14 

IV. THE UNITED STATES AND ICELAND: 

CROSS-BORDER INVESTMENT AND TRADE 

A. Introduction 

A principal rationale for negotiating tax treaties is to improve the business climate for 

business persons in one country who might aspire to sell goods and services to customers in the 

other country and to improve the investment climate for investors in one country who might 

aspire to own assets in the other country. Clarifying the application of the two nations’ income 

tax laws makes more certain the tax burden that will arise from different transactions, but may 

also increase or decrease that burden. Where there is, or where there is the potential to be, 

substantial cross-border trade or investment, changes in the tax structure applicable to the income 

from trade and investment has the potential to alter future flows of trade and investment. 

Therefore, in reviewing the proposed treaty it may be beneficial to examine the cross-border 

trade and investment between the United States and Iceland. Whether measured by trade in 

goods or services or by direct and non-direct cross-border investment, the United States and 

Iceland engage in modest cross-border activity at present. The income from cross-border trade 

and investment generally is subject to income tax in either the United States or Iceland and in 

many cases the income is subject both to gross basis withholding taxes in the source country and 

net basis income tax in the residence country. 
 

15 

B. Overview of International Transactions Between 

the United States and Iceland 

Cross-border trade

The current account consists of three primary components: trade in goods; trade in 

services; and payment of income on assets invested abroad. While detail regarding the balance 

of payments between the United States and Iceland is not publicly available, one can document 

the value of trade between the United States and Iceland. In 2007, the United States exported 

$630 million of goods to Iceland and imported $206 million in goods from Iceland. This made 

Iceland the United States’ 84th largest merchandise export destination and the 112th largest 

source of imported merchandise.33 

Cross-border investment

Income from foreign assets is categorized as income from “direct investments” and 

income from “non-direct investments.” Direct investment constitutes assets over which the 

owner has direct control. The Department of Commerce defines an investment as direct when a 

single person owns or controls, directly or indirectly, at least 10 percent of the voting securities 

of a corporate enterprise or the equivalent interest in an unincorporated business. Often the 

income that crosses borders from direct investments is in the form of dividends from a subsidiary 

to a parent corporation, although interest on loans between such related corporations is another 

source of income from a direct investment. In non-direct investments the investor generally does 

not have control over the assets that underlie the financial claims. Non-direct investments 

consist mostly of holdings of corporate equities and corporate and government bonds, generally 

referred to as “portfolio investments,” and bank deposits and loans. Hence, the income from 

non-direct investments generally is interest or dividends. 

Commensurate with the size of Iceland’s economy in comparison to other European 

countries, the value of cross-border investment, between the United States and Iceland is 

significantly smaller than that of cross border investment between the United States and other 

European countries. The Bureau of Economic Analysis estimates that the value of direct 

investments in Iceland held by U.S. averaged approximately $4 million annually on a historic 

cost basis for the period 2002 through 2005. The Bureau of Economic Analysis estimated 

Icelandic persons held direct investments in the United States valued at $2.2 billion in 2003 and 

that such direct investments had grown in value to $7.4 billion in 2005.34

 33 Bureau of Economic Analysis, U.S. Department of Commerce, “U.S. International Trade in 

Goods and Services, Annual Revision for 2007,” June 10, 2008. 

34 Jeffrey H. Lowe, “U.S. Direct Investment Abroad: Detail for Historical-Cost Position and 

Related Capital and Income Flows, 2004-2006,” Survey of Current Business, vol. 87, September 2007, 

and Jeffrey H. Lowe, “Foreign Direct Investment in the United States: Detail for Historical-Cost Position 

and Related Capital and Income Flows, 2004-2006,” Survey of Current Business, vol. 87, September 

2007. Data for 2006 suppressed to avoid disclosure of individual companies. Data related to direct 
 

16 

U.S. direct investments in Iceland produced approximately $4 million in income to U.S. 

persons in 2006. Icelandic direct investments in the United States produced approximately $263 

million in income to Icelandic persons in 2006.35 

The data presented above do not report the amount of U.S. or Icelandic portfolio 

investments, holdings of stocks and bonds (including holdings of U.S. government securities). 

The Bureau of Economic Analysis generally only reports portfolio holdings by country for the 

several largest portfolio investment countries. 

 

investment holdings by Icelandic persons in 2002 also were suppressed to avoid disclosure of individual 

companies.. 

35 Ibid. The Bureau of Economic Analysis reports income net of withholding taxes prior to 2006. 

Between 2002 and 2005 income to U.S. persons from direct investments in Iceland ranged from $1 

million to $2 million annually net of withholding taxes. To protect the confidentiality of individual 

companies, the Bureau of Economic Analysis did not disclose comparable data for income paid to owners 

of Icelandic direct investments located in the United States. 
 

17 

C. Analyzing the Economic Effects of Income Tax Treaties 

Among other things, tax treaties often change both the amount and timing of income 

taxes and the country (source or residence) that has priority to impose such taxes. If the tax treaty 

changes increase the after-tax return to cross-border trade and investment, or to particular forms 

of trade or investment, in the long run there could be significant economic effects. Generally, to 

the extent a treaty reduces barriers to capital and labor mobility, more efficient use of resources 

will result and economic growth in both countries will be enhanced, although there may be 

negative transitional effects occurring in specific industries or geographic regions. On the other 

hand, tax treaties may also lead to tax base erosion if they create new opportunities for tax 

arbitrage. Tax treaties also often increase and improve information sharing between tax 

authorities. Improvements in information sharing and the limitation of benefits provision should 

reduce the potential for outright evasion of U.S. and Icelandic income tax liabilities. 

Generally, the treaty-based reduced withholding rates in the present treaty are maintained 

in the proposed treaty. The reduced withholding rates encourage more cross-border investment 

and income flows between the treaty parties, compared to investments in nontreaty countries. 

Over the longer term, the withholding tax rates of the present and proposed treaties, coupled with 

other proposed changes in the present treaty, are likely to cause small revenue increases in later 

years as capital flows increase and from improved allocation of capital. 

However, this simple analysis is incomplete. A complete analysis of the proposed treaty 

would account for both tax and non-tax related factors, such as portfolio capital needs in the 

affected countries, and the corresponding relation between current and financial accounts. The 

potential for future growth in each country is an important determinant of cross-border 

investment decisions. In sum, even in the short run, the larger macroeconomic outlook, 

compared to treaty modifications, is likely to be a more important determinant of future crossborder income and investment flows and the related tax collections. 
 

18 

V. EXPLANATION OF PROPOSED TREATY AND PROTOCOL 

Article 1. General Scope

In general

The general scope article describes the persons who may claim the benefits of the 

proposed treaty. It also includes a “saving clause” provision similar to provisions found in most 

U.S. income tax treaties, and a special rule for fiscally transparent entities similar to that found in 

the U.S. Model treaty. 

Paragraph 1 provides that the proposed treaty generally applies only to residents of the 

United States and to residents of Iceland. The determination of whether a person is a resident of 

the United States or Iceland is made under Article 4 of the proposed treaty (Resident). Certain 

provisions are applicable to persons who may not be residents of either treaty country. For 

example, paragraph 1 of Article 23 (Non-Discrimination) applies to nationals of the treaty 

countries. Under Article 25 (Exchange of Information and Administrative Assistance), 

information may be exchanged with respect to residents of third countries. 

Paragraph 2 states the generally accepted relationship both between the treaty and 

domestic law, and between the treaty and other agreements to which the United States and 

Iceland are parties. It provides that the treaty does not restrict any benefit accorded by internal 

law or by any other agreement between the United States and Iceland. This means that the 

proposed treaty will not apply to increase the tax burden of a resident of either the United States 

or Iceland beyond that determined under internal law. 

Under the principles of paragraph 2, a taxpayer’s U.S. tax liability need not be 

determined under the proposed treaty if the Code would produce a more favorable result. The 

Technical Explanation states, however, that a taxpayer may not choose among the provisions of 

the Code and the proposed treaty in an inconsistent manner in order to minimize tax. The 

Technical Explanation includes an example illustrating this rule. In the example, a resident of 

Iceland has three separate businesses in the United States. One is a profitable permanent 

establishment and the other two are trades or businesses that would earn taxable income (or loss) 

under the Code but that do not meet the permanent establishment threshold tests of the proposed 

treaty. One is profitable and the other incurs a loss. Under the proposed treaty, the profits of the 

permanent establishment are taxable in the United States, and the income and loss of the other 

two businesses are ignored. Under the Code, all three would be subject to tax, but the loss would 

offset the income of the two profitable ventures. The Technical Explanation states that the 

taxpayer may not invoke the proposed treaty to exclude the income of the profitable trade or 

business and invoke the Code to claim the loss of the loss trade or business against the income of 

the permanent establishment. However, if the taxpayer invokes the Code for the taxation of all 

three ventures, he would not be precluded from invoking the proposed treaty with respect, for 

example, to any dividend income he may receive from the United States that is not effectively 

connected with any of his business activities in the United States. 

Notwithstanding the foregoing, paragraph 2 provides that: (1) the provisions of Article 24 

(Mutual Agreement Procedure) apply to any dispute concerning whether a measure is within the 
 

19 

scope of the proposed treaty, and that the procedures under the proposed treaty shall apply to that 

dispute; and (2) with respect to any taxation measure within the scope of the proposed treaty, the 

non-discrimination obligations of the proposed treaty apply exclusively (except for such national 

treatment or most-favored nation obligations as may apply to trade in goods under the General 

Agreement on Tariffs and Trade). For purposes of paragraph 2, a “measure” is a law, regulation, 

rule, procedure, decision, administrative action, or any similar provision or action. 

Saving clause

Like all U.S. income tax treaties and the U.S. Model treaty, the proposed treaty includes a 

“saving clause” in paragraph 4. Under this clause, with specific exceptions described below, the 

proposed treaty does not affect the taxation by either treaty country of its residents or its citizens. 

By reason of this saving clause, subject to the exceptions described below, the United States may 

continue to tax its citizens who are residents of Iceland as if the treaty were not in force. 

Paragraph 4 also provides that the United States may tax, in accordance with the laws of 

the United States, a former citizen or former long-term resident of the United States for a period 

of ten years following the loss of citizenship or long-term resident status. Section 877 of the 

Code provides special rules for the imposition of U.S. income tax (for a period of ten years) on 

certain former U.S. citizens and former long-term residents who relinquish their citizenship or 

cease to be a long-term resident prior to June 17, 2008. Under U.S. domestic law, an individual 

is considered a “long-term resident” of the United States if the individual (other than a citizen of 

the United States) was a lawful permanent resident of the United States in at least eight of the 15 

taxable years ending with the taxable year in which the individual ceased to be a long-term 

resident. 

For any individual who relinquishes U.S. citizenship or ceases to be a lawful permanent 

resident of the United States (“expatriates”) on or after June 17, 2008, the Heroes Earnings 

Assistance and Relief Tax Act of 2008,36 replaces section 877 with a new set of special rules. In 

general, to the extent those rules impose U.S. tax on an individual after the individual 

expatriates, they require or deem the individual to waive any rights to claim a reduction in U.S. 

tax under a U.S. tax treaty and any other rights under a U.S. tax treaty that would preclude the 

assessment or collection of tax imposed by the new rules. 

Paragraph 5 contains exceptions to the saving clause. Exceptions to the saving clause are 

provided for the following benefits conferred by the proposed treaty: the allowance of 

correlative adjustments when the profits of an associated enterprise are adjusted by the other 

country (Article 9, paragraph 2); benefits relating to social security payments and pensions 

(Article 17, paragraphs 2 and 4); relief from double taxation through the provision of a foreign 

tax credit (Article 22); protection from discriminatory tax treatment with respect to transactions 

with residents of the other country (Article 23); and benefits under the mutual agreement 

procedures of the treaty (Article 24). 

 36 Pub. L. No. 110-245, sec. 301 (June 17, 2008). 
 

20 

In addition, the saving clause does not apply to certain benefits conferred by the United 

States or Iceland upon individuals who are neither citizens of, nor have been admitted for 

permanent residence in, the United States or Iceland, respectively. Under this set of exceptions 

to the saving clause, the specified treaty benefits are available to, for example, a citizen of 

Iceland who spends enough time in the United States to be taxed as a U.S. resident but who has 

not acquired U.S. permanent residence status (i.e., does not hold a “green card”). The benefits 

that are covered under this set of exceptions are exemptions from host country taxation for 

certain income for government service (Article 18), certain income received by students, 

trainees, and researchers (Article 19), and certain income received by members of diplomatic 

missions and consular posts (Article 26). 

Fiscally transparent entities

Paragraph 6 sets forth a special rule for partnerships, trusts, and estates (“fiscally 

transparent entities”). Under this rule, income derived though an entity that is a partnership, 

trust, or estate under the laws of either treaty country is considered to be the income of a resident 

of one of the treaty countries only to the extent that the income is subject to tax in that country as 

the income of a resident, either in the hands of the entity or in the hands of its partners or 

beneficiaries. For example, if a corporation resident in Iceland distributes a dividend to an entity 

that is treated as fiscally transparent for U.S. tax purposes, the dividend will be considered 

derived by a resident of the United States only to the extent that U.S. tax laws treat one or more 

U.S. residents (whose status as U.S. residents is determined under U.S. tax laws) as deriving the 

dividend income for U.S. tax purposes. 

The Technical Explanation states that the result in the above example would be the same 

if the entity were viewed differently under the laws of Iceland (i.e., as not fiscally transparent). 

The Technical Explanation also states that this result follows regardless of whether the entity is 

organized in the United States, Iceland, or a third country. As an example, the Technical 

Explanation states that income from sources in Iceland received by an entity organized under the 

laws of Iceland, which is treated for U.S. tax purposes as a corporation and is owned by a U.S. 

shareholder who is a U.S. resident for U.S. tax purposes, is not considered derived by the 

shareholder of that corporation even if, under the tax laws of Iceland, the entity is treated as 

fiscally transparent. Finally, the Technical Explanation states that these results follow regardless 

of whether the entity is disregarded as a separate entity under the laws of one jurisdiction but not 

the other, such as a single owner entity that is viewed as a branch for U.S. tax purposes and as a 

corporation for Icelandic tax purposes. 

Paragraph 6 is not an exception to the saving clause in paragraph 4. Accordingly, 

paragraph 6 does not prevent a treaty country from taxing an entity that is treated as a resident of 

that treaty country under its tax laws. For example, if a U.S. corporation has Icelandic 

shareholders, the United States will tax the corporation on its worldwide income on a net basis, 

without regard to whether Iceland views the corporation as fiscally transparent. Similarly, if an 

entity organized in Iceland and owned by U.S. residents is treated as a corporation under the tax 

laws of Iceland, Iceland may tax the entity on its worldwide income on a net basis, even if the 

United States views the entity as fiscally transparent. 
 

21 

Article 2. Taxes Covered

The proposed treaty applies to all taxes on income irrespective of the manner in which 

they are levied, including taxes on gains from the alienation of property and on the total amounts 

of wages or salaries paid by enterprises, but excluding social security taxes and taxes on capital 

appreciation. In the case of Iceland, the proposed treaty applies to the income taxes to the state 

and the municipalities. In the case of the United States, the proposed treaty applies to the 

Federal income taxes imposed by the Code and to Federal excise taxes imposed with respect to 

private foundations. 

The proposed treaty also applies to any taxes that are identical or substantially similar to 

the taxes described in the preceding paragraph and that are imposed after the signing of the 

proposed treaty in addition to or in place of existing taxes. This provision generally is found in 

U.S. income tax treaties. The proposed treaty obligates the competent authority of each country 

to notify the competent authority of the other country of any significant changes in its internal 

taxation or other laws that significantly affect a country’s obligation under the proposed treaty. 

Article 3. General Definitions

This article provides definitions of a number of terms for purposes of the proposed treaty. 

Certain of the standard definitions found in most U.S. income tax treaties are included in the 

article. 

The article sets forth the geographical scope of the proposed treaty with respect to Iceland 

and the United States. In the case of Iceland, it encompasses the territory of Iceland, including 

its territorial sea, and any area beyond the territorial sea within which Iceland, in accordance 

with international law, exercises jurisdiction or sovereign rights with respect to the sea bed, its 

subsoil and its superadjacent waters, and their natural resources. In the case of the United States, 

it encompasses the United States of America, including the States and the District of Columbia, 

and the territorial sea thereof. It also includes the sea bed and the subsoil of the submarine areas 

adjacent to the territorial sea, over which the United States exercises sovereign rights in 

accordance with international law. The term does not include Puerto Rico, the Virgin Islands, 

Guam, or any other U.S. possession or territory. 

The term “person” includes an individual, a trust, a partnership, a company, and any other 

body of persons. 

The term “company” means a body corporate or an entity treated as a body corporate for 

tax purposes in the country where it is organized. 

The term “enterprise” applies to the carrying on of any business. The term “business” is 

not defined, but the proposed treaty provides that the term includes the performance of 

professional services and other activities of an independent character. According to the 

Technical Explanation, this is intended to clarify that income from the performance of 

professional services or other activities of an independent character is dealt with under Article 7 

(Business Profits) and not Article 20 (Other Income). 
 

22 

The terms “enterprise of a Contracting State” and “enterprise of the other Contracting 

State” mean, respectively, an enterprise carried on by a resident of a treaty country and an 

enterprise carried on by a resident of the other treaty country. The Technical Explanation 

clarifies that an enterprise of a treaty country need not be carried on in that country. 

The terms “a Contracting State” and “the other Contracting State” mean Iceland or the 

United States, as the context requires. 

The term “international traffic” means any transport by a ship or aircraft except when 

such transport is solely between places within a treaty country. This definition is applicable 

principally in the context of Article 8 (Shipping and Air Transport). 

The article designates the “competent authorities” for Iceland and the United States. In 

the case of Iceland, the competent authority is the Minister of Finance or his authorized 

representative. The U.S. competent authority is the Secretary of the Treasury or his delegate. 

According to the Technical Explanation, the Secretary of the Treasury has delegated the 

competent authority function to the Commissioner of Internal Revenue, who in turn has 

delegated the authority to the Deputy Commissioner (International) LMSB. 

The term “national,” as it relates to the United States and to Iceland, means (1) an 

individual who is a citizen or national of that State, and (2) any legal person, partnership, or 

association deriving its status, as such, from the laws of a contracting state. This term is relevant 

for purposes of Articles 18 (Government Service) and 23 (Non-Discrimination). 

The term “pension scheme” means any plan, scheme, fund, trust or other arrangement 

established in a treaty country that: (1) is generally exempt from income taxation in that country; 

and (2) operates principally to administer or provide pension or retirement benefits or to earn 

income for the benefit of one or more such arrangements. 

The protocol to the proposed treaty provides that, in the case of Iceland, any pension fund 

or pension plan qualified under the Pension Act or any identical or substantially similar schemes 

created under any law enacted after October 23, 2007, the date of signature of the proposed 

treaty, are considered to meet the requirements of a “pension scheme.” In the case of the United 

States, the protocol provides that the following plans are considered to meet these requirements: 

qualified plans under section 401(a) of the Code, individual retirement plans (including 

individual retirement plans that are part of a simplified employee pension plan that satisfies 

section 408(k), individual retirement accounts, individual retirement annuities, section 408(p) 

accounts, and Roth IRAs under section 408A), section 457(g) governmental plans, section 403(a) 

qualified annuity plans, section 403(b) plans, and any identical or substantially similar schemes 

created under any law enacted after October 23, 2007. In addition, the Technical Explanation 

clarifies that the Thrift Savings Fund provided in section 7701(j), section 401(k) plans, and 

certain other plans and group trusts qualify as pension schemes to the extent that they are section 

401(a) plans. 

Terms that are not defined in the proposed treaty are covered in paragraph 2. Paragraph 2 

provides that in the application of the proposed treaty, any term not defined in the proposed 

treaty will have the meaning that it has under the law of the county whose tax is being applied, 
 

23 

unless the context requires otherwise or the competent authorities have agreed on a different 

meaning pursuant to Article 24 (Mutual Agreement Procedure). If the term is defined under both 

the tax and non-tax laws of a treaty country, the definition in the tax law prevails. 

Article 4. Resident

The assignment of a country of residence is important because the benefits of the 

proposed treaty generally are available only to a resident of one of the treaty countries as that 

term is defined in the proposed treaty. Issues arising because of dual residency, including 

situations of double taxation, may be avoided by the assignment of one treaty country as the 

country of residence when under the internal laws of the treaty countries a person is a resident of 

both countries. 

Internal taxation rules

United States

Under U.S. law, an individual who spends sufficient time in the United States in any year 

or over a three-year period generally is treated as a U.S. resident. A permanent resident for 

immigration purposes (that is, a “green card” holder) also is treated as a U.S. resident. U.S. 

residents are taxed on their worldwide income. Under U.S. law, a company is taxed on its 

worldwide income if it is a “domestic corporation.” A domestic corporation is one that is created 

or organized in the United States or under the laws of the United States, a State, or the District of 

Columbia. 

Iceland

An individual is considered a resident of Iceland if he stays in Iceland for six months or 

longer. Under Icelandic law, resident individuals are subject to tax on their worldwide income, 

while nonresident individuals generally are subject to tax only on income arising in Iceland. 

A legal entity is a resident of Iceland if it is registered in Iceland, if its articles of 

incorporation provide that its home is in Iceland, or if its effective place of management is 

Iceland. Companies that are resident in Iceland are subject to tax on their worldwide income. A 

foreign company is subject to the Icelandic corporate tax on income derived through the carrying 

on of, participation in, or entitlement to a share of profits of a business through a permanent 

establishment in Iceland. 

Proposed treaty rules

Article 4 of the proposed treaty provides rules to determine whether a person is a resident 

of the United States or Iceland under the proposed treaty. The rules generally are consistent with 

the rules of the U.S. Model treaty. 

The proposed treaty generally defines “resident of a Contracting State” to mean any 

person who, under the laws of that treaty country, is liable to tax therein by reason of the 

person’s domicile, residence, citizenship, place of management, place of incorporation, or any 

other criterion of a similar nature. The term does not include any person who is liable to tax in 
 

24 

that treaty country only on income from sources in that country or on profits attributable to a 

permanent establishment in that country. Accordingly, although not explicitly stated in the 

proposed treaty, an enterprise of Iceland with a permanent establishment in the United States 

does not become a resident of the United States as a result of its U.S. permanent establishment. 

Such an enterprise generally is liable to tax by the United States only on income attributable to 

its U.S. permanent establishment, not on its worldwide income. 

The proposed treaty makes explicit the generally understood practice of including in the 

definition of “resident of a Contracting State” the two treaty countries and any political 

subdivisions or local authorities of those countries. 

The proposed treaty provides a special rule to treat as residents of a treaty country certain 

legal entities that generally are exempt from tax in that country. The provision applies to a 

pension scheme, which is any plan, scheme, fund, trust or other arrangement established in a 

treaty country that (1) is generally exempt from income taxation in that country, and (2) operates 

principally to administer or provide pension or retirement benefits or to earn income for the 

benefit of one or more such arrangements. The provision also applies to a plan, scheme, fund, 

trust, company, or other arrangement established in a treaty country that is operated exclusively 

to administer or provide employee benefits and that, by reason of its nature as such, is generally 

exempt from income taxation in that country. In addition, the provision applies to an 

organization that is a resident of a treaty country under its laws and is established exclusively for 

religious, charitable, scientific, artistic, cultural, or educational purposes. 

The proposed treaty provides a series of tie-breaker rules to determine residence in the 

case of an individual who, under the basic residence definition, would be considered to be a 

resident of both countries. These tie-breaker rules are to be applied in the order in which they 

are described below. Under these rules, an individual is deemed to be a resident of the country in 

which he or she has a permanent home available. If the individual has a permanent home in both 

countries, the individual’s residence is deemed to be the country with which his or her personal 

and economic relations are closer (that is, the individual’s “center of vital interests”). If it cannot 

be determined in which country the individual has his or her center of vital interests, or if the 

individual does not have a permanent home available in either country, the individual is deemed 

to be a resident of the country in which he or she has a habitual abode. If the individual has a 

habitual abode in both countries or in neither country, the individual is deemed to be a resident of 

the country of which he or she is a national. If the individual is a national of both countries or of 

neither country, the competent authorities of the countries will endeavor to settle the question of 

residence by mutual agreement. 

The proposed treaty also provides a tie-breaker rule for persons other than individuals 

(e.g., companies, trusts, or estates). If, under the general residence rules described above, a 

person other than an individual is a resident of both countries, the proposed treaty requires the 

competent authorities to endeavor to settle the issue of residence by mutual agreement. If the 

competent authorities are unable to reach mutual agreement, then that person will not be entitled 

to claim any benefits provided by the proposed treaty, except those provided by Article 23 (NonDiscrimination) and by Article 24 (Mutual Agreement Procedure). 
 

25 

Fiscally Transparent Entities

The residence treatment of items of income, profit, or gain derived through fiscally 

transparent entities is addressed in paragraph 6 of Article 1 (General Scope) of the proposed 

treaty. 

Article 5. Permanent Establishment

The proposed treaty contains a definition of the term “permanent establishment” that 

generally follows the language of other recent U.S. income tax treaties, the U.S. Model treaty, 

and the OECD Model treaty. 

The permanent establishment concept is one of the basic devices used in income tax 

treaties to limit the taxing jurisdiction of the host country and thus to mitigate double taxation. 

Generally, an enterprise that is a resident of one country is not taxable by the other country on its 

business profits unless those profits are attributable to a permanent establishment of the resident 

in the other country. In addition, the permanent establishment concept is used to determine 

whether the reduced rates of, or exemptions from, tax provided for dividends, interest, and 

royalties apply, or whether those items of income will be taxed as business profits. 

In general, under the proposed treaty, a permanent establishment is a fixed place of 

business in which the business of an enterprise is wholly or partly carried on. A permanent 

establishment includes a place of management, a branch, an office, a factory, a workshop, a 

mine, an oil or gas well, a quarry, or other place of extraction of natural resources. It also 

includes a building site or a construction or assembly project if it lasts for more than 12 months, 

and includes an installation used for the exploration for natural resources if the activity continues 

in the treaty country for more than 12 months. The Technical Explanation states that the 12-

month test applies separately to each individual site or project, with a series of contracts or 

projects that are interdependent both commercially and geographically treated as a single project. 

The Technical Explanation further states that if the 12-month threshold is exceeded, the site or 

project constitutes a permanent establishment as of the first day that work in the country began. 

The proposed treaty provides that the following activities of a preparatory or auxiliary 

character are deemed not to constitute a permanent establishment: (1) the use of facilities solely 

for storing, displaying, or delivering goods or merchandise belonging to the enterprise; (2) the 

maintenance of a stock of goods or merchandise belonging to the enterprise solely for storage, 

display, or delivery or solely for processing by another enterprise; and (3) the maintenance of a 

fixed place of business solely for the purchase of goods or merchandise or for the collection of 

information for the enterprise. The proposed treaty also provides that the maintenance of a fixed 

place of business solely for the purpose of carrying on, for the enterprise, any other activity of a 

preparatory or auxiliary character does not constitute a permanent establishment. The proposed 

treaty further provides that a combination of these activities will not give rise to a permanent 

establishment, if the combination results in an overall activity that is of a preparatory or auxiliary 

character. These rules are consistent with the OECD and U.S. Model treaties. 

Under the proposed treaty, if a person, other than an independent agent, is acting in a 

treaty country in the name of the enterprise of the other country and has, and habitually exercises 
 

26 

in such first country, the authority to conclude contracts in the name of such enterprise, the 

enterprise is deemed to have a permanent establishment in the first country in respect of any 

activities undertaken for that enterprise. This rule does not apply where the activities are limited 

to the activities described in the preceding paragraph that would not give rise to a permanent 

establishment if carried on by the enterprise through a fixed place of business. The Technical 

Explanation states that the language “in the name of the enterprise,” which also appears in the 

OECD Model treaty, is intended to have the same meaning as the language “binding on the 

enterprise” found in the U.S. Model treaty. Both phrases are intended to encompass persons who 

have sufficient authority to bind the enterprise’s participation in the business activity in the treaty 

country. 

No permanent establishment is deemed to arise under the proposed treaty if the agent is a 

broker, general commission agent, or any other agent of independent status, provided that the 

agent is acting in the ordinary course of its business. The Technical Explanation states that 

whether an enterprise and an agent are independent is a factual determination, and that the 

relevant factors in making this determination include: (1) the extent to which the agent operates 

on the basis of instructions from the principal; (2) the extent to which the agent bears business 

risk; and (3) whether the agent has an exclusive or nearly exclusive relationship with the 

principal. 

The proposed treaty provides that the fact that a company that is a resident of one country 

controls or is controlled by a company that is a resident of the other country or that carries on 

business in the other country does not cause either company to be a permanent establishment of 

the other. The Technical Explanation clarifies that, consistent with the U.S. Model treaty, such 

control is not taken into account in determining whether either company has a permanent 

establishment in the other treaty country. 

Article 6. Income from Immovable Property (Real Property)

This article covers income from immovable property (real property). The rules 

governing gains from the sale of immovable property (real property) are included in Article 13 

(Capital Gains). Under the proposed treaty, income derived by a resident of one country from 

immovable property (real property) situated in the other country may be taxed in that other 

country. This rule and, in general, the other rules of this article are consistent with the rules in 

the U.S. and OECD Model treaties. 

The term “immovable property (real property)” generally has the meaning that it has 

under the law of the country in which the property in question is situated. According to the 

Technical Explanation, in the case of the United States, the term “real property” has the meaning 

given to it by Treas. Reg. section 1.897-1(b). The proposed treaty provides, however, that 

regardless of internal law definitions, immovable property (real property) also includes property 

accessory to immovable property (real property), including livestock and equipment used in 

agriculture and forestry; rights to which the provisions of general law respecting landed property 

apply; usufruct of immovable property (real property); and rights to variable or fixed payments 

as consideration for the working of, or the right to work, mineral deposits, sources, and other 

natural resources. Ships, boats, and aircraft are not regarded as immovable property (real 

property). 
 

27 

The proposed treaty specifies that the country in which the property is situated also may 

tax income derived from the direct use, letting, or use in any other form of immovable property 

(real property). The rules permitting source-country taxation of income from immovable 

property (real property) also apply to the income from immovable property (real property) of an 

enterprise. However, the rules do not apply if the beneficial owner of the income, resident in one 

treaty country, has a permanent establishment in the other treaty country through which the 

beneficial owner carries on a business and the income from the immovable property (real 

property) is effectively connected with that permanent establishment. In such case, the 

provisions of Article 7 (Business Profits) apply. 

The proposed treaty does not grant an exclusive taxing right to the country where the 

property is located; such country is merely given the primary right to tax. The proposed treaty 

also does not impose any limitation in terms of the rate or form of tax such country may impose. 

Thus, the proposed treaty does not include paragraph 5 of Article 6 of the U.S. Model treaty, 

regarding the allowance of an election to be taxed on a net basis on income from real property. 

Net basis taxation, however, is available under the tax laws of both the United States and 

Iceland. Thus, taxpayers generally should be able to obtain the same treatment in the country 

where the real property is situated regardless of whether the income is treated as business profits 

attributable to a permanent establishment or income from real property. 

Article 7. Business Profits

Internal taxation rules

United States

U.S. law distinguishes between the U.S. business income and the other U.S. income of a 

nonresident alien or foreign corporation. A nonresident alien or foreign corporation is subject to 

a flat 30-percent rate (or lower treaty rate) of tax on certain U.S. source income if that income is 

not effectively connected with the conduct of a trade or business within the United States. The 

regular individual or corporate rates apply to income (from any source) that is effectively 

connected with the conduct of a trade or business within the United States. The performance of 

personal services within the United States may constitute a trade or business within the United 

States. 

The treatment of income as effectively connected with a U.S. trade or business depends 

upon whether the source of the income is U.S. or foreign. In general, U.S. source periodic 

income (such as interest, dividends, rents, and wages) and U.S. source capital gains are 

effectively connected with the conduct of a trade or business within the United States if the asset 

generating the income is used in (or held for use in) the conduct of the trade or business or if the 

activities of the trade or business are a material factor in the realization of the income. All other 

U.S. source income of a person engaged in a trade or business in the United States is treated as 

effectively connected with the conduct of a trade or business in the United States (under what is 

referred to as a “force of attraction” rule). 

The income of a nonresident alien individual from the performance of personal services 

within the United States is excluded from U.S.-source income, and therefore is not taxed by the 
 

28 

United States in the absence of a U.S. trade or business, if the following criteria are met: (1) the 

individual is not in the United States for over 90 days during the taxable year; (2) the 

compensation does not exceed $3,000; and (3) the services are performed as an employee of, or 

under a contract with, a foreign person not engaged in a trade or business in the United States, or 

are performed for a foreign office or place of business of a U.S. person. 

Foreign source income generally is effectively connected income only if the foreign 

person has an office or other fixed place of business in the United States and the income is 

attributable to that place of business. In those circumstances, only three types of foreign source 

income are considered to be effectively connected income: rents and royalties for the use of 

certain intangible property derived from the active conduct of a U.S. business; certain dividends 

and interest either derived in the active conduct of a banking, financing or similar business in the 

United States or received by a corporation the principal business of which is trading in stocks or 

securities for its own account; and certain sales income attributable to a U.S. sales office. 

Special rules apply for purposes of determining the foreign source income that is effectively 

connected with a U.S. business of an insurance company. 

Any income or gain of a foreign person for any taxable year that is attributable to a 

transaction in another year is treated as effectively connected with the conduct of a U.S. trade or 

business if it would have been so treated had it been taken into account in that other year (section 

864(c)(6)). In addition, if any property ceases to be used or held for use in connection with the 

conduct of a trade or business within the United States, the determination of whether any income 

or gain attributable to a sale or exchange of that property occurring within ten years after the 

cessation of business is effectively connected with the conduct of a trade or business within the 

United States is made as if the sale or exchange occurred immediately before the cessation of 

business (section 864(c)(7)). 

Iceland

Nonresident individuals are taxed only on their Icelandic-source income and capital 

gains. Icelandic-source business income derived by nonresidents is taxed the same as if derived 

by a resident. A foreign company is subject to the Icelandic corporate tax on income derived 

through the carrying on of, participation in, or entitlement to a share of profits of a business 

through a permanent establishment in Iceland. 

Proposed treaty limitations on internal law

Under the proposed treaty, business profits of an enterprise of a treaty country are taxable 

in the other treaty country only to the extent that they are attributable to a permanent 

establishment in the other country through which the enterprise carries on business. This rule is 

one of the basic treaty limitations on a country’s right to tax income of a resident of the other 

country. The rule is similar to the rules found in the U.S. and OECD Model treaties. 

Although the proposed treaty does not provide a definition of the term “business profits,” 

the Technical Explanation states that the term is intended to cover income derived from any trade 

or business. As a result of the definitions of “enterprise” and “business” in Article 3, this 

definition includes income from independent personal services, which, unlike the present treaty 
 

29 

but like the U.S. and OECD Model treaties, is not addressed in a separate article. Although the 

proposed treaty does not include a separate article for independent personal services, this article 

limits the right of a treaty country to tax income from the performance of personal services by a 

resident of the other treaty country in a manner similar to the limitations provided in the separate 

article applicable to independent personal services that is included in the present treaty. 

The Technical Explanation discusses significant features of the definition of “business 

profits.” The inclusion in business profits of income of an enterprise from personal services is 

consistent with the long-standing U.S. position that an enterprise’s personal services income is 

business profits. Accordingly, a consulting firm resident in one treaty country whose employees 

or partners perform services in the other treaty country through a permanent establishment may 

be taxed in that other country under Article 7, and not under Article 14 (Income from 

Employment) because that article applies only to income of employees. The term “business 

profits” also includes income attributable to notional principal contracts and other financial 

instruments to the extent that the income is attributable to a trade or business of dealing in such 

instruments or is otherwise related to a trade or business (as in the case of a notional principal 

contract entered into for the purpose of hedging currency risk arising from an active trade or 

business). Any other income derived from financial instruments is, according to the Technical 

Explanation, addressed in Article 20 (Other Income), unless specifically governed by another 

article. 

The proposed treaty provides rules for the attribution of business profits to a permanent 

establishment. Under these rules, the treaty countries attribute to a permanent establishment the 

business profits that the permanent establishment might be expected to make if it were a distinct 

and separate enterprise engaged in the same or similar activities under the same or similar 

conditions, and dealing wholly independently with the enterprise of which it is a permanent 

establishment. For this purpose, the business profits to be attributed to the permanent 

establishment include only the profits derived from the assets used, risks assumed, and activities 

performed by the permanent establishment. The proposed treaty and the Technical Explanation 

make clear that the principles of the OECD Transfer Pricing Guidelines apply for purposes of 

determining the profits attributable to a permanent establishment, but taking into account the 

different economic and legal circumstances of a single entity. The Technical Explanation notes 

that this rule confirms the arm’s length standard for purposes of determining the profits 

attributable to a permanent establishment. Any of the methods described in the Transfer Pricing 

Guidelines, including profits methods, may be used to determine the income of the permanent 

establishment as long as those methods are applied in accordance with the Transfer Pricing 

Guidelines. 

In applying the arm’s-length standard to determine the taxable business profits of a 

permanent establishment, the Technical Explanation observes that it is necessary to draw an 

economic (as well as legal) distinction between operating through a single legal entity rather than 

through separate legal entities. For example, an entity that operates through branches rather than 

separate subsidiaries will have lower capital requirements because all of the assets of the entity 

are available to support all of the entity’s liabilities (with some exceptions attributable to local 

regulatory restrictions). Thus, most commercial banks and some insurance companies operate 

through branches rather than subsidiaries. While the benefit that comes from such lower capital 

costs must be allocated among the branches in an appropriate manner, this issue does not arise in 
 

30 

the case of an enterprise that operates through separate entities because each entity must either be 

capitalized separately or compensate another entity for providing capital (e.g., through a 

guarantee). 

The Technical Explanation states that, whereas U.S. domestic law does not recognize 

internal transactions because they do not have legal significance, the rule provided by the 

proposed treaty is that such internal dealings may be used to allocate income in cases where the 

dealings accurately reflect the allocation of risk within the enterprise. For example, in the case 

of global dealing in securities, many banks use internal swap transactions to transfer risk from 

one branch to a central location where traders have the expertise to manage that particular type of 

risk. Under the proposed treaty, such banks also are permitted to use swap transactions as a 

means of allocating income between or among the branches, provided the allocation method used 

by the bank complies with the transfer pricing rules of U.S. internal law. However, the books of 

a branch will not be respected if the results are inconsistent with a functional analysis. For 

example, income from a transaction that is booked in a particular branch (or home office) would 

not be allocated to that location if the sales and risk management functions that generate such 

income are performed in another location. 

A permanent establishment cannot be funded entirely with debt, but must have sufficient 

capital to carry on its activities as if it were a distinct and separate enterprise. In general, if 

insufficient capital has been attributed to a permanent establishment for profit attribution 

purposes, a treaty country may attribute such capital to the permanent establishment, in 

accordance with the arm’s-length principle, and deny an interest deduction to the extent 

necessary to reflect that capital attribution. According to the Technical Explanation, both U.S. 

internal law and the proposed treaty start from the premise that all of the capital of the enterprise 

supports all of the assets and risks of the enterprise, and therefore the entire capital of the 

enterprise must be allocated to its various businesses and offices. 

The Technical Explanation notes, however, that U.S. internal law37 does not take into 

account the fact that some assets are more risky than other assets, and that, for example, an 

independent enterprise would require less capital to support a perfectly hedged U.S. Treasury 

security than it would to support an equity security or other asset with significant market and/or 

credit risk. Thus, U.S. internal law requires taxpayers in some cases to allocate more capital to 

the United States (and, thus, reduces the taxpayer’s interest deduction more) than may be 

appropriate. To address these cases, the Technical Explanation states that the proposed treaty 

permits taxpayers to apply a more flexible approach that takes into account the relative risk of its 

assets in the various jurisdictions in which it conducts business. In particular, with respect to 

financial institutions other than insurance companies, a treaty country may determine the amount 

of capital to be attributed to a permanent establishment by allocating the institution’s total equity 

between its various offices on the basis of the proportion of the financial institution’s riskweighted assets attributable to each of them. However, to ease the administrative burden arising 

because risk-weighting is more complicated than the method prescribed under U.S. internal law, 

the Technical Explanation also states that taxpayers may choose to apply the principles of U.S. 

 37 Treas. Reg. sec. 1.882-5. 
 

31 

internal law, rather than risk-weighted attribution, even if the taxpayer has otherwise chosen to 

apply Article 7 in lieu of the effectively connected income rules of U.S. internal law. 

The protocol to the proposed treaty provides a special rule with respect to profits 

attributable to Icelandic permanent establishments of U.S. insurance companies and U.S. 

permanent establishments of Icelandic insurance companies. The special rule provides that the 

provisions of Article 7 and Article 23 (Non-Discrimination) shall not prevent Iceland from 

continuing to tax permanent establishments of United States insurance companies in accordance 

with the Article 70, paragraph 2, section 3 of the Icelandic Tax Code, and shall not prevent the 

United States from continuing to tax permanent establishments of Icelandic insurance companies 

in accordance with section 842(b) of the Code. Section 842(b) provides that the amount of net 

investment income that is effectively connected with the conduct of an insurance business within 

the United States shall not be less than the product of (1) the assets required to support the U.S. 

insurance liabilities, and (2) the company’s U.S. investment yield. 

The proposed treaty provides that in computing taxable business profits of a permanent 

establishment, deductions are allowed for expenses, wherever incurred, that are for the purposes 

of the permanent establishment. These deductions include executive and general administrative 

expenses so incurred. The Technical Explanation states that deductions are allowed regardless of 

which accounting unit of the enterprise books the expenses, so long as the expenses are incurred 

for the purposes of the permanent establishment (including for the purposes of the enterprise as a 

whole or that part of the enterprise that includes the permanent establishment). The amount of 

expense that must be allowed as a deduction is determined by applying the arm’s-length 

principle. The Technical Explanation states that a permanent establishment may deduct 

payments made to its head office or another branch in compensation for services performed for 

the benefit of the branch, provided the deduction comports to the arm’s-length standard. The 

method for computing the amount of such a deduction would depend upon the terms of the 

arrangements between the branches and head office. 

The Technical Explanation states that, if a deduction would be allowed under the Code in 

computing taxable income, the deduction is also allowed in computing taxable income under the 

proposed treaty. However, except where the proposed treaty provides for more favorable 

treatment, a taxpayer cannot take deductions for expenses in computing taxable income under the 

proposed treaty to a greater extent than would be allowed under the Code where doing so would 

be inconsistent with the intent of the Code. For example, if an Icelandic taxpayer with a 

permanent establishment in the United States borrows $100 to purchase U.S. tax-exempt bonds, 

and the bonds and related debt would be treated as assets and liabilities of the permanent 

establishment, both the tax-exempt interest from the bonds and the interest expense from the 

related debt would be excluded for purposes of computing the profits attributable to the 

permanent establishment under the proposed treaty. 

Like the U.S. and OECD Model treaties, the proposed treaty provides that business 

profits are not attributed to a permanent establishment merely by reason of the purchase of goods 

or merchandise by the permanent establishment for the enterprise of which it is a part. 

According to the Technical Explanation, this rule applies only to an office that performs 

functions in addition to purchasing because purchasing does not by itself give rise to a permanent 

establishment under Article 5 (Permanent Establishment) to which income can be attributed. 
 

32 

When it applies, the rule provides that business profits may be attributable to a permanent 

establishment for its non-purchasing activities (e.g., sales activities), but not for its purchasing 

activities. 

The proposed treaty requires that the determination of the business profits of a permanent 

establishment be made using the same method year by year unless there is a good and sufficient 

reason to the contrary. The Technical Explanation states that this rule limits the ability of both 

the treaty country and the enterprise to change accounting methods to be applied to the 

permanent establishment. 

Where business profits include items of income that are dealt with separately in other 

articles of the proposed treaty, those other articles, and not the business profits article, generally 

govern the treatment of those items of income. Thus, for example, the taxation of dividends is 

determined under the rules of Article 10 (Dividends), and not by the rules of Article 7, except as 

specifically provided in Article 10 (that is, when dividends are attributable to a permanent 

establishment). 

The proposed treaty provides that, for purposes of the taxation of business profits, income 

may be attributable to a permanent establishment (and therefore may be taxable in the source 

country) even if the payment of the income is deferred until after the permanent establishment 

has ceased to exist. This rule incorporates into the proposed treaty the rule of section 864(c)(6) 

described above. This rule applies for purposes of the rules for business profits under this article, 

dividends (Article 10, paragraph 4), interest (Article 11, paragraph 3), royalties (Article 12, 

paragraph 4), gains (Article 13, paragraph 3) and other income (Article 20, paragraph 2). 

The Technical Explanation notes that Article 7 is subject to the saving clause of 

paragraph 4 of Article 1 (General Scope). Thus, in the case of the saving clause, if a U.S. citizen 

who is a resident of Iceland 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 4 of Article 22 (Relief from Double Taxation), 

tax those profits, notwithstanding that paragraph 1 of this article would exempt the income from 

U.S. tax. 

Article 8. Shipping and Air Transport

Article 8 of the proposed treaty covers income from the operation of ships and aircraft in 

international traffic. The rules governing income from the disposition of ships, aircraft, and 

containers are in paragraph 4 of Article 13 (Gains). 

The United States generally taxes the U.S.-source income of a foreign person from the 

operation of ships or aircraft to or from the United States. An exemption from U.S. tax is 

provided if the income is earned by a corporation or nonresident alien individual organized or 

resident in a foreign country that grants an equivalent exemption to U.S. corporations and 
 

33 

residents. As a result of the present treaty, Iceland is considered to grant an equivalent 

exemption.38

Like the present treaty, the proposed treaty provides that profits of an enterprise of one 

treaty country from the operation of ships or aircraft in international traffic are taxable only in 

that country. Paragraph 6 of Article 7 (Business Profits) provides that if profits include items of 

income that are described in both Article 7 and other articles of the proposed treaty, including 

Article 8, the provisions of those other articles are not affected by the provisions of Article 7. 

The rules of Article 8, therefore, are not affected by the general rule of Article 7 that profits 

attributable to a permanent establishment that an enterprise of a treaty country has in the other 

treaty country may be taxed in the other treaty country. Consequently, the profits of an 

enterprise of a treaty country from the operation of ships or aircraft in international traffic may 

not be taxed in the other treaty country even if the enterprise has a permanent establishment in 

that other treaty country. 

“International traffic” is defined in Article 3(1)(h) (General Definitions) as any transport 

by a ship or aircraft, except when the transport is solely between places in a treaty country. 

The proposed treaty provides that profits from the operation of ships or aircraft in 

international traffic include profits derived from the rental of ships or aircraft on a full basis (i.e., 

rental with crew, whether on a time or voyage basis). As in the U.S. Model treaty, profits from 

the operation of ships or aircraft in international traffic also include profits from the rental of 

ships or aircraft on a bareboat basis (that is, without crew), whether the ships or aircraft are 

operated in international traffic by the lessee or the rental income is incidental to the lessor’s 

other profits from the operation of ships or aircraft in international traffic. 

The proposed treaty provides that profits of an enterprise from the inland transport of 

property or passengers within either treaty country are treated as profits from the operation of 

ships or aircraft in international traffic (and, therefore are governed by Article 8) if the transport 

is undertaken as part of international traffic. Thus, according to the Technical Explanation, if a 

U.S. enterprise contracts to carry property from Iceland to a U.S. city and as part of that contract 

transports the property by truck from its point of origin to an airport in Iceland (or contracts with 

a trucking company to carry the property to the airport), the income earned by the U.S. enterprise 

from the overland leg of the transport is taxable only in the United States. Similarly, the 

Technical Explanation states that Article 8 also applies to all income derived from a contract for 

the international transport of goods even if the goods are transported to the port by a lighter (a 

barge used in loading and unloading ships), and not by the vessel that carries the goods in 

international waters. 

The proposed treaty provides that profits of an enterprise of a treaty country from the use, 

maintenance, or rental of containers (including trailers, barges, and related equipment for the 

transport of containers) used in international traffic are taxable only in that treaty country. 

According to the Technical Explanation, this exclusive residence country taxation applies even if 

 38 See Rev. Rul. 2008-17, 2008-12 I.R.B. 626 (Mar. 24, 2008). 
 

34 

the enterprise is not engaged in the operation of ships or aircraft in international traffic and even 

if the enterprise has a permanent establishment in the other treaty country. 

As under the U.S. Model treaty, the shipping and air transport provisions of the proposed 

treaty apply to profits from participation in a pool, a joint business, or an international operating 

agency. These arrangements are common methods of cooperation among international shipping 

and air transport companies. 

The Technical Explanation notes that Article 8 is subject to the saving clause of 

paragraph 4 of Article 1 (General Scope). Consequently, if a U.S. citizen who is a resident of 

Iceland derives profits from the operation of ships or aircraft in international traffic, the United 

States may tax those profits as part of the citizen’s worldwide income (subject to the proposed 

treaty’s foreign tax credit rules). The benefit of exclusive residence country taxation is available 

to an enterprise of a treaty country only if that enterprise satisfies the limitation on benefits 

requirements of Article 21. 

Article 9. Associated Enterprises

The proposed treaty, like most other U.S. tax treaties, contains an arm’s-length pricing 

provision. The proposed treaty recognizes the right of each country to make an allocation of 

profits to an enterprise of that country in the case of transactions between related enterprises, if 

conditions are made or imposed between the two enterprises in their commercial or financial 

relations that differ from those that would be made between independent enterprises. In such a 

case, a country may allocate to such an enterprise the profits that it would have accrued but for 

the conditions so imposed. This treatment is consistent with the U.S. and OECD Model treaties. 

For purposes of the proposed treaty, an enterprise of one country is related to an 

enterprise of the other country if one of the enterprises participates directly or indirectly in the 

management, control, or capital of the other enterprise. Enterprises are also related if the same 

persons participate directly or indirectly in the enterprises’ management, control, or capital. 

Under the proposed treaty, when a redetermination of tax liability has been made by one 

country under the provisions of this article, and the other country agrees with that 

redetermination, then that other country will make an appropriate adjustment to the amount of 

tax paid in that country on the redetermined income. In making such a correlative, or 

corresponding, adjustment, the other provisions of the proposed treaty must be taken into 

account. For example, if the correlative adjustment is treated as a distribution of profits from a 

U.S. company for U.S. tax purposes, then the five-percent U.S. withholding tax, as provided by 

Article 10 (Dividends) of the proposed treaty, would apply to the correlative adjustment. 

Based on a specific exception, the proposed treaty’s saving clause, which retains full 

taxing jurisdiction in the country of residence or citizenship, does not apply in the case of 

correlative adjustments. Accordingly, the statute of limitations of a treaty country does not 

prevent the allowance of any appropriate correlative adjustments that may be necessary 

following an adjustment described in this article. For example, if a correlative adjustment would 

result in a refund, but the applicable statute of limitations for the refund claim has expired, the 

refund can still be made. However, the Technical Explanation states that statutory or procedural 
 

35 

limitations cannot be overridden to impose additional tax, because paragraph 2 of Article 1 

(General Scope) provides that the proposed treaty cannot restrict any statutory benefit. 

Article 10. Dividends

Overview

The dividends article of the proposed treaty generally allows full residence-country 

taxation and limited source-country taxation of dividends. The proposed treaty includes a 

generally applicable maximum rate of withholding at source of 15 percent and a reduced fivepercent maximum rate for dividends received by a company owning at least 10 percent of the 

dividend-paying company. A zero rate of withholding tax generally applies to dividends 

received by pension schemes and employee benefits organizations. Special rules apply to 

dividends received from RICs and REITs. These special rules are similar to provisions included 

in other recent treaties and protocols. 

Internal taxation rules

United States

The United States generally imposes a 30-percent tax on the gross amount of U.S.-source 

dividends paid to nonresident alien individuals and foreign corporations. The 30-percent tax 

does not apply if the foreign recipient is engaged in a trade or business in the United States and 

the dividends are effectively connected with that trade or business. In that case, the foreign 

recipient is subject to U.S. tax on the dividends on a net basis at graduated rates in the same 

manner in which a U.S. person would be taxed. 

Under U.S. law, the term “dividend” generally means any distribution of property made 

by a corporation to its shareholders from current or accumulated earnings and profits. 

In general, corporations are not entitled under U.S. law to a deduction for dividends paid. 

Thus, the withholding tax on dividends theoretically represents imposition of a second level of 

tax on corporate taxable income. Treaty reductions of this tax reflect the view that where the 

United States already imposes corporate-level tax on the earnings of a U.S. corporation, a 

30-percent withholding rate may represent an excessive level of source-country taxation. 

Moreover, the reduced rate of tax often applied by treaty to dividends paid to direct investors 

reflects the view that the source-country tax on payments of profits to a substantial foreign 

corporate shareholder may properly be reduced further to avoid double corporate-level taxation 

and to facilitate international investment. 

A REIT is a U.S. domestic corporation, trust, or association that is subject to the regular 

corporate income tax, but that receives a deduction for dividends paid to its shareholders if 

certain conditions are met. To qualify for the deduction for dividends paid, a REIT must 

distribute most of its income. As a result of the deduction for dividends paid, a REIT generally 

does not pay Federal income tax. Except for capital gain dividends, a distribution of REIT 

earnings is generally treated by the recipient as a dividend rather than as income of the same type 
 

36 

as the underlying earnings.39 This distribution is subject to the U.S. 30-percent withholding tax 

when paid to foreign owners. However, the receipt of a distribution from a REIT is generally 

treated as a disposition of a U.S. real property interest by the recipient to the extent that it is 

attributable to a sale or exchange of a U.S. real property interest by the REIT.40

REITs generally are organized to allow investment in primarily passive real estate 

investments. As such, income of a REIT often includes rentals from real estate holdings or 

interest from loans secured by real estate mortgages. Like dividends, U.S.-source rental income 

of foreign persons generally is subject to the 30-percent withholding tax (unless the recipient 

makes an election to have the rental income taxed in the United States on a net basis at the 

regular graduated rates). Unlike the withholding tax on dividends, however, the withholding tax 

on rental income generally is not reduced in U.S. income tax treaties. When rental income (or 

interest income) of a REIT is distributed to a foreign shareholder as a REIT dividend, it is treated 

as a dividend under U.S. internal law. U.S.-source interest income of foreign persons is not 

subject to U.S. withholding tax in certain circumstances. A REIT dividend does not, however, 

pass through to the REIT’s shareholders the interest characterization of the REIT’s underlying 

earnings. 

U.S. internal law also generally treats a RIC as both a corporation and as an entity not 

subject to corporate tax to the extent it distributes substantially all of its income. The purpose of 

a RIC is to allow investors to hold diversified portfolios of securities. Dividends paid by a RIC 

generally are treated as dividends received by the payee, and the RIC generally pays no tax 

because it is permitted to deduct dividends paid to its shareholders in computing its taxable 

income. However, a RIC generally may pass through to its shareholders the character of its net 

long-term and, for taxable years beginning before January 1, 2008, net short-term capital gains 

by designating a dividend it pays as a long-term or short-term capital gain dividend, to the extent 

that the RIC has net capital gains. Nonresident aliens and foreign corporations generally are not 

subject to tax on capital gains. A distribution in a taxable year beginning before January 1, 2008 

to a nonresident alien or foreign corporation made by a RIC that is (or, if certain exceptions were 

disregarded, would be) a U.S. real property holding corporation, however, is treated as gain 

recognized by that nonresident alien or foreign corporation from the sale or exchange of a U.S. 

real property interest to the extent the gain is attributable to gain from sales or exchanges of U.S. 

real property interests.41

 39 Because a REIT generally does not pay corporate-level tax, certain U.S. benefits of dividend 

treatment are not available. A U.S. corporate shareholder is not generally entitled to a dividends-received 

deduction for REIT dividends. REIT dividends generally are not qualified dividends eligible for the 15-

percent rate available for individual shareholders. 

40 There is an exception for distributions to a shareholder that owns five percent or less of the 

REIT, if the REIT stock is regularly traded on an established securities market located in the United 

States. Sec. 897(h)(1). These distributions are treated as dividends under U.S. internal law. 

41 The exception described in the immediately preceding footnote also applies for distributions 

by RICs. 
 

37 

A RIC that earns interest income that would not be subject to U.S. tax if earned by a 

foreign person directly (“qualified interest income”)42 generally may designate a dividend it pays 

in a taxable year beginning before January 1, 2008 as derived from that interest income, to the 

extent of that income. Nonresident aliens and foreign corporations are not subject to tax on such 

interest-related dividends. The aggregate amount that may be designated by a RIC as interestrelated dividends generally is limited to the sum of qualified interest income less the amount of 

expenses of the RIC properly allocable to the interest income. 

Iceland

Dividends paid by Icelandic resident companies to nonresident individuals and 

companies generally are subject to a 10-percent withholding tax. 

Proposed treaty limitations on internal law

In general

Under the proposed treaty, dividends paid by a company that is a resident of a treaty 

country to a resident of the other country may be taxed in that other country. The dividends also 

may be taxed by the country in which the payor company is resident, but the rate of tax is 

limited. Under the proposed treaty, source-country taxation of dividends (that is, taxation by the 

country in which the dividend-paying company is resident) generally is limited to 15 percent of 

the gross amount of the dividends paid to residents of the other treaty country. A lower rate of 

five percent applies if the beneficial owner of the dividends is a company that owns directly at 

least 10 percent of the voting stock of the dividend-paying company. 

The term “beneficial owner” is not defined in the proposed treaty and therefore is defined 

under the internal law of the country imposing tax (that is, the source country). The Technical 

Explanation states that the beneficial owner of a dividend for purposes of this article is the 

person to which the dividend income is attributable for tax purposes under the laws of the source 

country. 

According to the Technical Explanation, however, special rules apply to companies 

holding shares through fiscally transparent entities, such as partnerships. In such cases, the rules 

of paragraph 6 of Article 1 (General Scope) of the proposed treaty apply to determine whether 

the dividends should be treated as derived by a resident of a treaty country. The laws of the 

residence country determine who derives the dividend, and the laws of the source country 

 42 Qualified interest income of the RIC is equal to the sum of its U.S.-source income with respect 

to: (1) bank deposit interest; (2) short term original issue discount that is currently exempt from the 

gross-basis tax under section 871; (3) any interest (including amounts recognized as ordinary income in 

respect of original issue discount, market discount, or acquisition discount under the provisions of 

sections 1271-1288, and such other amounts as regulations may provide) on an obligation that is in 

registered form, unless it is earned on an obligation issued by a corporation or partnership in which the 

RIC is a 10-percent shareholder or is contingent interest not treated as portfolio interest under section 

871(h)(4); and (4) any interest-related dividend from another RIC. 
 

38 

determine whether the person who derives the dividends is the beneficial owner of the dividends. 

The principles of paragraph 6 of Article 1 (General Scope) of the treaty also apply to determine 

whether other requirements have been satisfied, such as the ownership threshold that must be 

met to qualify for the 10-percent rate under this article. 

The proposed treaty provides a zero rate of withholding tax for dividends received by a 

pension scheme or employee benefits organization, provided that the dividends are not derived 

from the carrying on of a business, directly or indirectly, by the pension scheme or employee 

benefits organization. The proposed treaty defines a pension scheme as a plan, scheme, fund, 

trust, or other arrangement established in the United States or Iceland that is operated principally 

to administer or provide pension or retirement benefits or to earn income for the benefit of one or 

more such arrangements and that is generally exempt from taxation in the treaty country in 

which it is established. 

Dividends paid by U.S. RICs and REITs

The proposed treaty generally denies the five-percent rate of withholding tax to dividends 

paid by U.S. RICs and REITs. 

The 15-percent rate of withholding generally is allowed for dividends paid by a RIC. The 

15-percent rate of withholding is allowed for dividends paid by a REIT, provided one of three 

additional conditions is met: (1) the beneficial owner of the dividend is an individual holding an 

interest of not more than 10 percent in the REIT; (2) the dividend is paid with respect to a class 

of stock that is publicly traded, and the beneficial owner of the dividend is a person holding an 

interest of not more than five percent of any class of the REIT’s stock; or (3) the beneficial 

owner of the dividend holds an interest in the REIT of not more than 10 percent, and the REIT is 

diversified (that is, the value of no single interest in real property held by the REIT exceeds 10 

percent of the total interests of the REIT in real property). 

The Technical Explanation indicates that the restrictions on availability of the lower rate 

are intended to prevent the use of RICs and REITs to gain inappropriate U.S. tax benefits. For 

example, a company resident in Iceland could directly own a diversified portfolio of U.S. 

corporate shares and pay a U.S. withholding tax of 15 percent on dividends on those shares. 

Absent the additional RIC restrictions, there is a concern that such a company instead might 

purchase 10 percent or more of the interests in a RIC, which could even be established as a mere 

conduit, and thereby obtain a lower withholding tax rate by holding the portfolio through the RIC 

(transforming portfolio dividends generally taxable at 15 percent into direct investment 

dividends taxable under the treaty at five percent). 

Similarly, the Technical Explanation provides an example of a resident of Iceland that 

directly holds real property and is required to pay U.S. tax either at a 30-percent rate on gross 

income or at graduated rates on the net income from the property. By placing the property in a 

REIT, the investor could transform real estate income into dividend income, taxable at the lower 

rates provided in the proposed treaty. The limitations on REIT dividend benefits are intended to 

protect against this result. 
 

39 

The proposed treaty also provides that the above rules apply to dividends paid by 

Icelandic companies that are similar to U.S. RICs and REITs. The determination of whether 

Icelandic companies are similar to U.S. RICs and REITs will be made by mutual agreement of 

the competent authorities. 

Definitions and special rules and limitations

The proposed treaty generally defines dividends as income from shares or other corporate 

participation rights that are not treated as debt, as well as other amounts that are subject to the 

same tax treatment by the source country as income from shares (for example, constructive 

dividends). 

The proposed treaty’s reduced rates of tax on dividends do not apply if the dividend 

recipient carries on business through a permanent establishment in the source country and the 

holding in respect of which the dividends are paid is effectively connected with that permanent 

establishment. In this case, the dividends are taxed as business profits (Article 7). 

The proposed treaty prevents each treaty country from imposing a tax on dividends paid 

by a resident of the other treaty country unless the dividends are paid to a resident of the first 

country or are attributable to a permanent establishment in that country. 

The proposed treaty allows each treaty country to impose a branch profits tax on a 

company resident in the other country if the company has income attributable to a permanent 

establishment in that country, derives income from real property in that country that is taxed on a 

net basis under the treaty, or realizes gains taxable in that country under the treaty. In the case of 

the United States, the base of the tax is limited to the “dividend equivalent amount,” consistent 

with the branch profits tax under U.S. internal law (section 884). In the case of Iceland, the base 

of the tax is limited to an amount that is analogous to the dividend equivalent amount. The rate 

of branch profits tax is limited to five percent. 

Relation to other articles

The Technical Explanation notes that the saving clause of paragraph 4 of Article 1 of the 

treaty (General Scope) permits the United States to tax dividends received by its residents and 

citizens, subject to the special foreign tax credit rules of paragraph 4 of Article 22 (Relief from 

Double Taxation), as if the proposed treaty had not come into effect. 

The benefits of the dividends article are also subject to the provisions of Article 21 of the 

treaty (Limitation on Benefits). 

Article 11. Interest

Internal taxation rules

United States

Subject to several exceptions (such as those for portfolio interest, bank deposit interest, 

and short-term original issue discount), the United States imposes a 30-percent withholding tax 
 

40 

on U.S.-source interest paid to foreign persons under the same rules that apply to dividends. 

U.S.-source interest, for purposes of the 30-percent tax, generally is interest on the debt 

obligations of a U.S. person, other than a U.S. person that satisfies specified foreign business 

requirements. Also subject to the 30-percent tax is interest paid by the U.S. trade or business of 

a foreign corporation. A foreign corporation is subject to a branch-level tax on certain “excess 

interest” of a U.S. trade or business of that corporation. Under this rule, an amount equal to the 

excess of the interest deduction allowed to the U.S. business over the interest paid by the 

business is treated as if paid by a U.S. corporation to a foreign parent and, therefore, is subject to 

the 30-percent withholding tax. 

Portfolio interest generally is defined as any U.S.-source interest that is not effectively 

connected with the conduct of a trade or business if the interest (1) is paid on an obligation that 

satisfies certain registration requirements or specified exceptions and (2) is not received by a 10-

percent owner of the issuer of the obligation, taking into account shares owned by attribution. 

The portfolio interest exemption does not apply to certain contingent interest income. 

If an investor holds an interest in a fixed pool of real estate mortgages that is a real estate 

mortgage interest conduit (“REMIC”), the REMIC generally is treated for U.S. tax purposes as a 

pass-through entity, and the investor is subject to U.S. tax on a portion of the REMIC’s income 

(generally, interest income). If the investor holds a so-called “residual interest” in the REMIC, 

the Code provides that a portion of the net income of the REMIC that is taxed in the hands of the 

investor – referred to as the investor’s “excess inclusion” – may not be offset by any net 

operating losses of the investor, must be treated as unrelated business income if the investor is an 

organization subject to the unrelated business income tax, and is not eligible for any reduction in 

the 30-percent rate of withholding tax (by treaty or otherwise) that would apply if the investor 

otherwise were eligible for such a rate reduction. 

Iceland

Icelandic-source interest payments made to nonresident individuals and foreign 

corporations are not subject to tax in Iceland. 

Proposed treaty limitations on internal law

The proposed treaty provides that interest arising in one treaty country (the source 

country) and beneficially owned by a resident of the other treaty country generally is exempt 

from tax in the source country. This exemption from source-country tax is similar to that 

provided in the U.S. Model treaty and the present treaty. The present treaty, however, applies to 

interest derived by, rather than beneficially owned by, a resident of a treaty country. 

The proposed treaty defines interest as income from debt-claims of every kind, whether 

or not secured by mortgage and whether or not carrying a right to participate in the debtor’s 

profits. In particular, interest includes income from government securities and from bonds or 

debentures, including premiums and prizes attaching to those securities, bonds, or debentures. 

The term “interest” also includes all other income that is treated as income from money lent 

under the tax law of the treaty country in which the income arises. Interest does not include 
 

41 

income covered in Article 10 (Dividends). Penalty charges for late payment also are not treated 

as interest. 

The exemption from source country taxation does not apply if the beneficial owner of the 

interest carries on business through a permanent establishment in the source country and the 

debt-claim in respect of which the interest is paid is effectively connected with that permanent 

establishment. (The Technical Explanation describes interest as being “attributable to” the 

permanent establishment, a common usage in U.S. income tax treaties, rather than adopting the 

U.S. Model treaty’s phrase that a debt-claim is “effectively connected with” a permanent 

establishment.) In that circumstance, the interest is taxed as business profits (Article 7). 

According to the Technical Explanation, interest attributable to a permanent establishment but 

received after the permanent establishment is no longer in existence is taxable in the country in 

which the permanent establishment existed. 

The proposed treaty addresses non-arm’s-length interest charges between a payer and a 

beneficial owner that have a special relationship. Paragraph 4 of Article 11 provides that the 

article applies only to the amount of interest that would have been agreed in the absence of a 

special relationship. Any excess amount is taxable according to the laws of each treaty country, 

with due regard being given to other provisions of the proposed treaty. For example, excess 

interest paid to a parent corporation may be treated as a dividend under a country’s internal laws 

and, accordingly, would be entitled to the benefits of Article 10 (Dividends). The Technical 

Explanation notes that the term “special relationship” is not defined in the proposed treaty and 

states that the United States considers the term to include the relationships described in Article 9 

(Associated Enterprises). Those relationships, according to the Technical Explanation, involve 

control as defined under the transfer pricing rules of section 482. 

The proposed treaty provides two anti-abuse exceptions to the general source-country 

exemption from tax on interest. The first exception relates to contingent interest payments. If 

interest is paid by a source-country resident and is determined with reference to (1) receipts, 

sales, income, profits, or other cash flow of the debtor or a related person, (2) any change in the 

value of any property of the debtor or a related person, or (3) any dividend, partnership 

distribution, or similar payment made by the debtor or a related person, the interest may be taxed 

in the source country in accordance with its laws. If the beneficial owner is a resident of the 

other treaty country, however, the interest may not be taxed at a rate exceeding 15 percent (that 

is, the rate prescribed in paragraph 2(b) of Article 10 (Dividends)). 

The second anti-abuse exception provides that the exemption from source-country 

taxation does not apply to interest that is an excess inclusion with respect to a residual interest in 

a REMIC. That interest may be taxed by each treaty country in accordance with its domestic 

law. The Technical Explanation states that this exception is consistent with the policy of 

sections 860E(e) and 860G(b) that excess inclusions with respect to a REMIC should bear full 

U.S. tax in all cases. 

The Technical Explanation notes that the benefits of Article 11, like benefits provided by 

other articles, are subject to the saving clause of paragraph 4 of Article 1 (General Scope) and are 

available only if a resident satisfies the limitation-on-benefits requirements of Article 21. 
 

42 

Article 12. Royalties

Internal taxation rules

United States

Under the same system that applies to dividends and interest, the United States imposes a 

30-percent withholding tax on U.S.-source royalties paid to foreign persons. U.S.-source 

royalties include royalties for the use of or right to use intangible property in the United States. 

Iceland

Royalty payments made to nonresident companies are subject to tax on their net amount. 

Because the royalties are subject to withholding tax at the general corporate rate, any tax 

withheld is credited against the final tax liability. 

Proposed treaty limitations on internal law

The proposed treaty provides that royalties arising in a treaty country (the source country) 

and beneficially owned by a resident of the other treaty country are generally exempt from tax in 

the source country. This exemption from source country tax is similar to that provided in the 

U.S. Model treaty (except as noted below) and the present treaty. However, paragraph 2 of 

Article 12 (Royalties) provides an exception to the general rule. Specifically, certain royalties 

may still be taxed by the source country at a rate of up to five percent. Royalties that are subject 

to the withholding tax are those paid in consideration for the use of, or the right to use: (1) a 

trademark and any information concerning industrial, commercial or scientific experience 

provided in connection with a rental or franchise agreement that includes rights to use a 

trademark; and (2) a motion picture film or work on film, videotape or other means of 

reproduction for use in connection with television. 

The term “royalties” as used in this article means payments of any kind received as 

consideration for the use of, or the right to use, any copyright of literary, artistic, or scientific 

work (including cinematographic films and computer software), any patent, trade mark, design 

or model, plan, secret formula or process, or for information concerning industrial, commercial, 

or scientific experience. As in the U.S. Model treaty, the term no longer includes payments 

made as consideration for “any like right or property,” thereby narrowing the scope of the term. 

Unlike the provision in the U.S. Model treaty, the term “royalties” does not include 

contingent gain from the alienation of any right or property described above. “Contingent gain” 

is gain contingent on the productivity, use, or disposition of the right or property. The treatment 

of such gain (as well as other gains from the alienation of such property) is addressed in Article 

13 (Gains). The Technical Explanation states that the term royalties does not include income 

from leasing personal property. 

The exemption from source country tax does not apply if the beneficial owner of the 

royalties carries on a business through a permanent establishment in the source country, and the 

right or property with respect of which the royalties are paid is effectively connected with such 

permanent establishment. In that event, the royalties are taxed as business profits (Article 7). 
 

43 

According to the Technical Explanation, royalties attributable to a permanent establishment but 

received after the permanent establishment is no longer in existence remains taxable under the 

provisions of Article 7 (Business Profits), and not under Article 12. 

In determining the source of royalties paid, paragraph 5 generally treats royalties as 

arising in the treaty country if they are paid by a resident of that country. An exception is carved 

out with respect to royalties that arise from the use of royalty-generating property by a 

permanent establishment located in a treaty country. If the expenses of such royalties are borne 

by the permanent establishment (i.e., they taken into account in determining taxable income of 

the permanent establishment), then they are considered to have arisen in that treaty country. If 

the payor is a resident of neither treaty country, but the royalties are paid with respect to the use 

of property in one of the treaty country, then the royalty will be considered as arising in the 

country of use. 

The proposed treaty addresses the issue of non-arm’s-length royalties between related 

parties (or parties otherwise having a special relationship) by providing that this article applies 

only to the amount of arm’s-length royalties. Any amount of royalties paid in excess of the 

arm’s-length interest is taxable according to other provisions of the proposed treaty. For 

example, excess royalties paid by a subsidiary corporation to its parent corporation may be 

treated as a dividend under local law and, thus, entitled to the benefits of Article 10 (Dividends). 

Article 13. Capital Gains

Internal taxation rules

United States

Generally, gain realized from the sale of a capital asset by a nonresident alien individual 

or a foreign corporation is not subject to U.S. tax unless the gain is effectively connected with 

the conduct of a U.S. trade or business or, in the case of a sale by a nonresident alien individual, 

that individual is physically present in the United States for at least 183 days in the taxable year. 

A nonresident alien individual or foreign corporation generally is subject to U.S. tax on gain 

from the sale of a U.S. real property interest as if the gain were effectively connected with a trade 

or business conducted in the United States. “U.S. real property interests” include interests in 

certain corporations if U.S. real property comprises at least 50 percent of the assets of the 

corporation. 

Iceland

Icelandic-source capital gains derived by nonresident companies on movable and 

immovable property and certain intangibles generally are subject to tax by Iceland. Icelandicsource capital gains derived by nonresident individuals on movable and immovable property 

generally are subject to tax by Iceland. 
 

44 

Proposed treaty limitations on internal law

The proposed treaty provides rules governing when a treaty country may tax gains from 

the alienation of property by a resident of the other treaty country. The rules generally are 

consistent with those included in the U.S. Model treaty. 

Under the proposed treaty, gains derived by a resident of one treaty country that are 

attributable to the alienation of immovable property (real property) situated in the other country 

may be taxed in that other country. For the purposes of this article, immovable property (real 

property) situated in the other treaty country includes: (1) immovable property (real property) 

referred to in Article 6 (Income from Immovable Property (Real Property))—that is, an interest 

in the immovable property (real property) itself; (2) rights to assets to be produced by the 

exploration or exploitation of the sea bed and subsoil of that other treaty country and their natural 

resources, including rights to interests in, or the benefit of, such assets; (3) in the case of the 

United States, a U.S. real property interest; and (4) in the case of Iceland, (a) shares, including 

rights to acquire shares, that are not regularly traded on a stock exchange and that derive their 

value, or more than 50 percent of their value, directly or indirectly from immovable property 

(real property) situated in Iceland, and (b) an interest in a partnership or trust to the extent that 

the assets of that partnership or trust consist of immovable property (real property) situated in 

Iceland or shares described in (4)(a). Under U.S. internal law, a U.S. real property interest 

includes, among other property, shares in a U.S. corporation that owns sufficient U.S. real 

property interests to satisfy an asset-based test. 

The proposed treaty includes a standard provision that permits a treaty country to tax 

gains from the alienation of movable property (that is, property other than immovable property 

(real property)) that forms a part of the business property of a permanent establishment that an 

enterprise of the other treaty country has in the first treaty country. This rule permits sourcecountry taxation of gains from the alienation of the permanent establishment (alone or with the 

enterprise as a whole). According to the Technical Explanation, this taxation is permitted 

whether or not the permanent establishment exists at the time of alienation. Consequently, 

income that is attributable to a permanent establishment, but that is deferred and is received after 

the permanent establishment no longer exists, may nevertheless be taxed in the treaty country in 

which the permanent establishment was located. This rule is similar to a rule in U.S. internal 

law. 

The Technical Explanation notes that a resident of Iceland that is a partner in a 

partnership doing business in the United States generally will have a permanent establishment in 

the United States as a result of the activities of the partnership. Under the proposed treaty, the 

United States may tax the partner’s distributive share of income realized by the partnership on 

the disposition of movable property forming part of the partnership’s business property in the 

United States. 

The proposed treaty provides that gains derived by an enterprise of one treaty country 

from the alienation of ships, aircraft, or containers operated or used in international traffic, or of 

personal property related to the operation of the ships, aircraft, or containers, are taxable only in 

that country. This rule applies even if the gains are attributable to a permanent establishment 

maintained by the enterprise in the other treaty country. 
 

45 

Gain from the alienation of any property other than the property described above is 

taxable under the proposed treaty only in the country in which the person alienating the property 

is a resident. 

The proposed treaty includes a special rule that permits the imposition of certain 

expatriation taxes. This rule provides that gains derived by a resident of one treaty country from 

the alienation of shares or rights in a company resident in the other treaty country may be taxed 

in that other country if the person alienating the shares or rights was a resident of that other 

country at any time during the five-year period immediately preceding the alienation of such 

shares. 

The Technical Explanation states that the saving clause of paragraph 4 of Article 1 

(General Scope) permits the United States to tax its citizens and residents as if the proposed 

treaty had not come into effect. In addition, the benefits of this Article 13 are available only to a 

treaty country resident that satisfies one of the conditions in Article 21 (Limitation on Benefits). 

Finally, the provision allowing a treaty country to tax certain gains derived by a resident of the 

other treaty country from the alienation of shares or share rights shall be applied in conjunction 

with subparagraph 2(b) of Article 22 (Relief from Double Taxation). 

Article 14. Income from Employment

Under the proposed treaty, salaries, wages, and other similar remuneration derived from 

services performed as an employee in one treaty country (the source country) by a resident of the 

other treaty country are taxable only by that person’s country of residence if three conditions are 

met: (1) the individual is present in the source country for not more than 183 days in any 12-

month period commencing or ending in the taxable year or year of assessment concerned; (2) the 

individual is paid by, or on behalf of, an employer who is not a resident of the source country; 

and (3) the remuneration is not borne by a permanent establishment of the employer in the source 

country (whether or not such expenses are actually deductible when determining the taxable 

income of the permanent establishment). These limitations on source country taxation are 

similar to the rules of the U.S. and OECD Model treaties. 

The proposed treaty contains a special rule that permits remuneration derived by a 

resident of one treaty country with respect to employment as a regular member of the crew of a 

ship or aircraft operated in international traffic by an enterprise of the other treaty country to be 

taxed only in the first treaty country. A similar rule is included in the U.S. and OECD Model 

treaties. U.S. internal law does not impose tax on such income of a person who is neither a 

citizen nor a resident of the United States, even if the person is employed by a U.S. entity. 

The Technical Explanation to the proposed treaty provides that it applies to compensation 

of any type, including payments in kind and stock options. Further, it applies without regard to 

the timing of the payment. Thus, a bonus paid to a resident of a treaty country with respect to 

services provided in the other treaty country would be subject to the terms of Article 14 (Income 

from Employment) even if the bonus is paid in a subsequent year. 

This article is subject to the provisions of the separate articles covering directors’ fees 

(Article 15), pensions, social security, and annuities (Article 17) and government service (Article 
 

46 

18). Thus, even though a treaty country may have the right to tax income from employment 

under this article, the right may be preempted if the income is also described, for example, in 

Article 18 (Government Service). 

Article 15. Directors’ Fees

Under the proposed treaty, director’s fees and other similar payments derived by a 

resident of one country for services rendered in his or her capacity as a member of the board of 

directors of a company that is a resident of the other treaty country are taxable in that other treaty 

country. For this purpose, it is not relevant where the director performs such services. The 

Technical Explanation points out, however, that U.S. law will not tax the services of a 

nonresident alien unless such services are performed (1) within the United States, or (2) by a 

U.S. citizen that is nonresident. In the later case, such services may be taxed by the U.S. 

pursuant to paragraph 4 of Article 1 (General Scope), which preserves to each treaty country the 

right to tax its citizens and residents. 

Article 16. Entertainers and Sportsmen

Article 16 of the proposed treaty addresses the taxation of services performed in a treaty 

country by entertainers and sportsmen resident in the other treaty country. The Technical 

Explanation provides that Article 16 applies to the income of an entertainer or sportsman who 

performs services both on his own behalf and on behalf of another person, either as an employee 

of that person or pursuant to any other arrangement. The article makes it possible to avoid the 

practical difficulties which often arise in taxing entertainers and sportsmen performing abroad. 

The rules of this article take precedence, in some circumstances, over those of Articles 7 

(Business Profits) and 14 (Income from Employment). 

In general 

Paragraph 1 describes the circumstances in which a treaty country may tax the local 

performance income of an entertainer or sportsman who is a resident of the other treaty country. 

Under the paragraph, income derived by an individual resident of a treaty country from activities 

as an entertainer or sportsman exercised in the other treaty country may be taxed in that other 

country if the amount of the gross receipts derived by the performer for the taxable year exceeds 

$20,000 (or its equivalent in Icelandic kronur). The Treasury Explanation states that the 

determination as to whether the $20,000 threshold has been exceeded is determined separately 

with respect to each year of payment. 

According to the Technical Explanation, the monetary threshold is designed to reach 

entertainers and athletes who are paid relatively large sums of money for very short periods of 

service, and who would, therefore, normally be exempt from host-country tax under the standard 

personal services income rules. The monetary threshold is consistent with the U.S. Model treaty. 

Tax may be imposed under paragraph 1 even if the performer would have been exempt 

from tax under Article 7 or 14. On the other hand, if the performer would be exempt from hostcountry tax under Article 16, but would be taxable under either Article 7 or 14, tax may be 

imposed under either of those articles. For example, a performer who receives less than the 

$20,000 threshold amount and therefore is not taxable under Article 16 nevertheless may be 
 

47 

subject to tax in the host country under Article 7 or 14 if the tests for host-country taxability 

under the relevant article are met. 

Paragraph 5 of the protocol to the proposed treaty provides that a treaty country may 

withhold tax from payments subject to Article 16 according to its domestic laws. However, if 

according to the provisions of Article 16, such remuneration or income may only be taxed in the 

other treaty country, the first-mentioned country must refund the tax so withheld upon a duly 

filed claim. 

The Technical Explanation provides that Article 16 applies to all income connected with 

a performance by the entertainer, such as appearance fees, award or prize money, and a share of 

the gate receipts. Income derived from a treaty country by a performer who is a resident of the 

other treaty country from other than actual performance, such as royalties from record sales and 

payments for product endorsements, is not covered by Article 16, but by other articles of the 

treaty, such as Article 12 (Royalties) or Article 7. The Treasury Explanation provides that in 

determining whether income falls under Article 16 or another article, the controlling factor will 

be whether the income in question is predominantly attributable to the performance itself or to 

other activities or property rights. 

According to the Treasury Explanation, where an individual fulfills a dual role as 

performer and non-performer (such as a player-coach or an actor-director), but his role in one of 

the two capacities is negligible, the predominant character of the individual's activities should 

control the characterization of those activities. In other cases, there should be an apportionment 

between the performance-related compensation and other compensation. 

Income accrues to another person 

Paragraph 2 of Article 16 is intended to address the potential for circumvention of the 

rule in paragraph 1 when a performer’s income does not accrue directly to the performer himself, 

but instead accrues to another person. 

The relationship may truly be one of employee and employer, with no circumvention of 

paragraph 1 either intended or realized. On the other hand, the “employer” may, for example, be 

a company established and owned by the performer, which is merely acting as the nominal 

income recipient in respect of the remuneration for the performance (a “star company”). The 

performer may act as an “employee,” receive a modest salary, and arrange to receive the 

remainder of the income from his performance from the company in another form or at a later 

time. In such case, absent the provisions of paragraph 2, the income arguably could escape hostcountry tax because the company earns business profits but has no permanent establishment in 

that country. The performer may largely or entirely escape host-country tax by receiving only a 

small salary, perhaps small enough to place him below the dollar threshold in paragraph 1. 

Paragraph 2 seeks to prevent this type of abuse. Under paragraph 2, when the income 

accrues to a person other than the performer, and the performer or related persons participate, 

directly or indirectly, in the receipts or profits of that other person, the income may be taxed in 

the treaty country where the performer’s services are exercised, without regard to the provisions 

of the proposed treaty concerning business profits (Article 7). Taxation under paragraph 2 is 
 

48 

imposed on the person providing the services of the performer. Paragraph 2 does not affect the 

rules of paragraph 1, which apply to the performer himself. According to the Technical 

Explanation, the income taxable by virtue of paragraph 2 is reduced to the extent of salary 

payments to the performer, which fall under paragraph 1 or Article 7 or 14. 

For purposes of paragraph 2, income is deemed to accrue to another person (i.e., the 

person providing the services of the performer) if that other person has control over, or the right 

to receive, gross income in respect of the services of the performer. Direct or indirect 

participation in the profits of a person may include, but is not limited to, the accrual or receipt of 

deferred remuneration, bonuses, fees, dividends, partnership income or other income, or 

distributions. The Treasury Explanation includes an example illustrating that the payment of 

salaries by a company to performers is not sufficient to establish that the performers participate 

in the profits of the company, where the performers receive their salaries out of the company’s 

gross receipts. 

Relationship to other articles

Article 16 is subject to the provisions of the saving clause of paragraph 4 of Article 1 

(General Scope). Thus, if an entertainer or a sportsman who is resident in Iceland is a citizen of 

the United States, the United States may tax all of his income from performances in the United 

States without regard to the provisions of Article16, subject to the foreign tax credit provisions of 

Article 22 (Relief From Double Taxation), including the special provisions in paragraph 4 of 

Article 22. In addition, the benefits of this article are subject to the provisions of Article 21 

(Limitation on Benefits). 

Article 17. Pensions, Social Security, and Annuities

This article deals with the taxation of private pensions, social security benefits, annuities, 

and, to a limited extent, pension schemes, as defined in Article 3(l). This article does not cover 

payments of government pensions covered under Article 18 (Government Service). 

Pension distributions

The proposed treaty includes the provision of the U.S. Model treaty under which 

pensions and other similar remuneration paid to a resident of a treaty country in consideration of 

past employment is taxable only in that country. The proposed treaty does not include the 

provision of the U.S. Model treaty that precludes the individual’s country of residence from 

taxing the portion of pension income arising in the other country that would have been exempt in 

the source country if the beneficiary were a resident there. Consequently, Iceland may tax 

according to its internal tax law a distribution of a Roth IRA to a resident of Iceland. The 

proposed treaty also does not include the provisions of the U.S. Model treaty that address crossborder contributions to pension funds. 

According to the Technical Explanation, the term “pensions and other similar 

remuneration” includes both periodic and lump sum payments and is intended to encompass 

payments made by qualified private retirement plans. According to the Technical Explanation, 

in the United States, the plans encompassed by “pensions and other similar remuneration” 

include: qualified plans under section 401(a), individual retirement plans (including individual 
 

49 

retirement plans that are part of a simplified employee pension plan that satisfies section 408(k), 

individual retirement accounts and section 408(p) accounts), section 403(a) qualified annuity 

plans, and section 403(b) plans. Distributions from section 457 plans may also meet this 

definition if they are not paid with respect to government services covered by Article 18. In 

Iceland, the term “pensions and other similar remuneration” applies to any pension fund or 

pension plan qualified under the Pension Act or any identical or substantially similar schemes 

which are created under any law enacted after the signature of the proposed treaty. 

Pensions in respect of government services covered by Article 18 are not covered by the 

term “pensions and other similar remuneration.” Such pensions are covered either by paragraph 

2 of this article, if they are in the form of social security benefits, or by paragraph 2 of Article 18. 

Timing of pension income and pension schemes

The proposed treaty provides that neither country may tax a resident of a treaty country 

on pension income earned through a pension scheme that is a resident of the other country until 

such income is distributed. When a resident receives a distribution from a pension fund, such 

distribution is subject to taxation in accordance with the provisions of this article (or if relevant, 

Article 18). For example, if a U.S. citizen contributes to a U.S. qualified plan while working in 

the United States and then establishes residence in Iceland, Iceland is prevented from taxing 

currently that pension scheme’s earnings and accretions with respect to that individual. Unlike 

the U.S. Model treaty, however, the proposed treaty does not address “rollover” distributions 

from a pension fund in one treaty country to a pension fund in the same country. Therefore, for 

example, Iceland may tax its residents on a rollover distribution from one U.S. pension fund to 

either another U.S. pension fund or an Icelandic pension fund. 

The term “pension scheme” is defined in paragraph 1(l) of Article 3 (General Definitions) 

and means any plan, scheme, fund, trust or other arrangement established in a treaty country that 

(1) is generally exempt from income taxation in that country, and (2) operates principally to 

administer or provide pension or retirement benefits or to earn income for the benefit of one or 

more such arrangements. This definition is discussed in the description of Article 3. 

Social security benefits

The proposed treaty, like the present treaty and the U.S. Model treaty, provides for 

exclusive source-country taxation of payments made under provisions of social security or 

“similar legislation.” This provision is an exception to the saving clause of paragraph 4 of 

Article 1 (General Scope) by virtue of subparagraph 5(a) of Article 1. Thus, only Iceland and 

not the United States may tax Icelandic social security benefits paid to a U.S. citizen. The 

provision under the proposed treaty applies to both private sector and government employees. 

The term “similar legislation” is intended to refer to United States tier 1 Railroad Retirement 

benefits. 

Annuities

The proposed treaty also provides that annuities (other than those paid for services 

rendered) derived and beneficially owned by an individual resident of either country are taxable 

only in the recipient’s country of residence. This is similar to the rule in the U.S. Model treaty. 
 

50 

The term “annuities” is defined for purposes of this provision as a stated sum paid periodically at 

stated times during a specified number of years, under an obligation to make the payments in 

return for adequate and full consideration (other than services rendered). The Technical 

Explanation states that an annuity received in consideration for services rendered would be 

treated either as deferred compensation and generally taxable in accordance with Article 14 

(Income from Employment) or as a pension subject to the pension rules of this article. 

Alimony and child support

Unlike the U.S. Model treaty, the proposed treaty does not expressly address the 

treatment of alimony and child support payments. Therefore, both are treated as other income 

that is subject to residence-country taxation under Article 20 (Other Income). In general, this is 

the same treatment for alimony as under the present treaty. Under the U.S. Model treaty, 

however, child support payments are exempt from tax in both treaty countries. 

Saving clause

Paragraphs 1 and 3 of Article 17 are subject to the saving clause of paragraph 4 of Article 

1 (General Scope). Thus, for example, a U.S. citizen who is a resident of Iceland and receives a 

pension or annuity payment from the United States may be subject to U.S. tax on the payment, 

notwithstanding the rules in those paragraphs that give the recipient’s country of residence the 

exclusive taxing right. Paragraphs 2 and 4 of Article 17 are excepted from the saving clause by 

virtue of subparagraph 5(a) of Article 1. Thus, the United States will not tax U.S. citizens and 

residents on the income described in those paragraphs even if such amounts otherwise would be 

subject to tax under U.S. law. 

Article 18. Government Service

Under paragraph 1 of Article 18 of the proposed treaty, remuneration, other than a 

pension, paid to an individual for services rendered to a treaty country (or political subdivision or 

local authority) is taxable only in that country. However, the remuneration is taxable only in the 

other country if the services are rendered there and the individual is a resident of that other 

country who is either a national of that other country or who did not become a resident of that 

other country solely for the purpose of rendering the services. According to the Technical 

Explanation, the provision applies to anyone performing services for a government, whether as 

an employee, an independent contractor, or an employee of an independent contractor. 

Paragraph 2 of Article 18 covers any pension paid by, or out of funds created by, a treaty 

country that is not in the form of social security benefits and is in respect of government service 

rendered to a treaty county (or subdivision or authority) by an individual. Such a pension is 

taxable only in that country. However, such a pension is taxable only in the other country if the 

individual is both a resident and a national of the other country. According to the Technical 

Explanation, pensions paid to retired civilian and military employees of the government of either 

country are intended to be covered under paragraph 2. 

When benefits paid by a treaty country in respect of services rendered to that country (or 

subdivision or authority) are in the form of social security benefits, those payments are covered 

by paragraph 2 of Article 17 (Pensions, Social Security, and Annuities). As a general matter, the 
 

51 

result will be the same whether Article 17 or 18 applies, since both social security benefits and 

government pensions are taxable exclusively by the source country. According to the Technical 

Explanation, the result differs only when the payment is made to a citizen and resident of the 

other country, who is not also a citizen of the paying country. In such a case, social security 

benefits continue to be taxable at source while government pensions are taxable only in the 

residence country. 

The treatment of payments described in paragraphs 1 and 2 of this article are subject to 

the provisions of those paragraphs and not to those of Articles 14 (Income from Employment), 

15 (Directors’ Fees), 16 (Entertainers and Sportsmen) or, except as noted above for social 

security payments, 17 (Pensions, Social Security, and Annuities). If, however, the remuneration 

or pension is paid for services performed in connection with a business carried on by a treaty 

country (or subdivision or authority), those other articles, and not Article 18, apply. 

Under subparagraph 5(b) of Article 1 (General Scope), the saving clause (paragraph 4 of 

Article 1) does not apply to the benefits conferred by one of the treaty countries under Article 18 

if the recipient of the benefits is neither a citizen of that country, nor a person who has been 

admitted for permanent residence (i.e., in the United States, a “green card” holder). As an 

example, the Technical Explanation states that a resident of a treaty country who in the course of 

performing functions of a governmental nature for that country becomes a resident of the other 

country (but not a permanent resident), would be entitled to the benefits of Article 18. The 

Technical Explanation states that, similarly, an individual who receives a pension paid by the 

Government of Iceland in respect of services rendered to the Government of Iceland shall be 

taxable on this pension only in Iceland unless the individual is a U.S. citizen or acquires a U.S. 

green card. 

Article 19. Students and Trainees 

Under the proposed treaty, the treatment provided to students and business trainees is 

similar to the provisions of the U.S. Model treaty and the OECD Model treaty. 

Under the proposed treaty, an individual resident of one treaty country who visits the 

other treaty country (“host country”) will be exempt from income tax in the host country on 

certain payments received if the primary purpose of the visit is: (1) to study at a university or 

other recognized educational institution in the host country; (2) to secure training required to 

qualify the individual to practice a profession or professional specialty; or (3) to study or perform 

research as the recipient of a grant, allowance, or award from a governmental, religious, 

charitable, scientific, literary, or educational organization. 

With respect to students, the exempt payments are limited to those payments the 

individual receives for his or her maintenance, education, study, research, and training that come 

from sources abroad; grants, allowances, or awards; and income from personal services 

performed in the host country up to a limit of $9,000 or its Icelandic kronur equivalent. The 

exemption from income tax in the host country applies only for a period of five years from the 

time the visitor first arrives in the host country. 
 

52 

With respect to trainees, the individual must be a resident of one treaty country and 

temporarily present in the host country as an employee of, or under contract with, a resident of 

the first treaty country, and the primary purpose of the visit must be either to acquire technical, 

professional, or business experience from a person other than the employer or a person related to 

the employer or to study at a university or other recognized educational institution in the host 

country. The proposed treaty provides that such individuals are exempt from host country 

taxation on up to $9,000 (or its Icelandic kronur equivalent) in personal services income for a 

period of up to one year. 

With respect to an individual resident of treaty country who visits the host country as a 

participant of a host-country government-sponsored program of training, research, or study, the 

individual will be exempt from host country taxation on up to $9,000 (or its Icelandic kronur 

equivalent) of income from personal services in respect of training, research, or study performed 

in the host country. To qualify for this exemption, the individual cannot be temporarily resident 

in the host country for more than one year. 

Article 20. Other Income

Article 20 assigns taxing jurisdiction over items of income beneficially owned by a 

resident of a contracting state and not dealt with in the other articles of the proposed treaty. The 

general rule is that such items are taxable only in the country of residence. This rule is similar to 

the rules in the U.S. and OECD Model treaties. 

In order for an item of income to be “dealt with” in another article it must be the type of 

income described in the article and, in most cases, it must have its source in one of the treaty 

countries. For example, royalty income that is beneficially owned by a resident of a treaty 

county is “dealt with” in Article 12 (Royalties) if the royalty income arises in the other treaty 

country, but not if the royalty income arises in a third country. However, profits derived in the 

conduct of a business are “dealt with” in Article 7 (Business Profits) whether or not they have 

their source in one of the treaty countries. 

According to the Technical Explanation, examples of types of items of income covered 

by Article 20 include income from gambling, punitive (but not compensatory) damages, and 

covenants not to compete. Article 20 also applies to income from a variety of financial 

transactions, where such income does not arise in the course of the conduct of a trade or 

business. Unlike the U.S. Model treaty, the proposed treaty does not specifically address 

alimony or child support. Accordingly, such items would be covered by Article 20. 

Distributions from partnerships are not generally dealt with under Article 20 because 

partnership distributions generally do not constitute income. Under the Code, partners include in 

income annually their distributive share of partnership income, and partnership distributions 

themselves generally do not give rise to income. This would also be the case under U.S. law 

with respect to distributions from trusts. Trust income and distributions that, under the Code, 

have the character of the associated distributable net income would generally be covered by 

another article of the proposed treaty. 
 

53 

The general rule of residence taxation does not apply to income (other than income from 

immovable property (real property) as defined in paragraph 2 of Article 6) if the beneficial 

owner of the income is a resident of one country and carries on business in the other country 

through a permanent establishment situated therein, and the income is attributable to such 

permanent establishment. In such a case, the provisions of Article 7 (Business Profits) will 

apply. 

Article 20 is subject to the saving clause in paragraph 4 of Article 1 (General Scope). 

Accordingly, U.S. citizens who are residents of Iceland will continue to be taxable by the United 

States on income to which this article applies, including relevant third-country income. This 

article is also subject to the provisions of Article 21 (Limitation on Benefits). Thus, if a resident 

of Iceland earns income that falls within the scope of paragraph 1 of Article 21, but that is 

taxable by the United States under U.S. law, the income would be exempt from U.S. tax under 

the provisions of Article 20 only if the resident satisfies one of the tests of Article 21 for entitlement to benefits. 

Article 21. Limitation on Benefits

In general

Article 21 of the proposed treaty includes rules that are similar to the limitation-onbenefits provisions included in other recent U.S. income tax treaties and protocols. These rules 

are intended to prevent the indirect use of the treaty by persons who are not entitled to its 

benefits by reason of residence in the United States or Iceland. The current treaty does not 

include a limitation-on-benefits provision. 

The proposed treaty is intended to limit double taxation caused by the interaction of the 

tax systems of the United States and Iceland as they apply to residents of the two countries. At 

times, however, residents of third countries attempt to benefit from a treaty by engaging in treaty 

shopping. Treaty shopping by a third-country resident may involve organizing, in a treaty 

country, a corporation that is entitled to the benefits of the treaty. Alternatively, a third-country 

resident eligible for favorable treatment under the tax rules of its country of residency may 

attempt to reduce the income base of a treaty country resident by having that treaty country 

resident pay to it, directly or indirectly, interest, royalties, or other amounts that are deductible in 

the treaty country from which the payments are made. Limitation-on-benefits provisions are 

intended to deny treaty benefits in certain cases of treaty shopping or income stripping engaged 

in by third-country residents. 

Generally, a resident of either treaty country is entitled to all the benefits accorded by the 

proposed treaty if the resident has any one of six listed attributes. The six attributes are that the 

resident is: (1) an individual; (2) one of the two treaty countries or a political subdivision or 

local authority of one of the two countries; (3) a company that satisfies a public company test or 

that is a subsidiary of a public company; (4) a pension scheme or employee benefits organization 

that satisfies a beneficiaries test; (5) an organization that is established in its country of residence 

exclusively for religious, charitable, scientific, artistic, cultural, or educational purposes, even if 

all or part of its income or gains are exempt from tax under the residence country’s domestic 

law; or (6) an entity that satisfies an ownership test and a base erosion test. A resident that has 
 

54 

none of these six attributes may be entitled to treaty benefits with respect to certain items of 

income under the derivative benefits test or the active business test. 

Special anti-abuse rules govern items of income derived from one of the treaty countries 

by an enterprise resident in the other treaty country in so-called “triangular cases.” In addition, a 

special rule applies in certain cases in which a company that is resident in one treaty country, or 

a company that controls such a company directly or indirectly, has outstanding a class of shares 

entitling a shareholder to a disproportionate part of the company’s income. 

A person that does not satisfy any of the requirements described above may be entitled to 

the benefits of the treaty if the source country’s competent authority so determines. 

Six attributes for qualification for all treaty benefits

Individual

Under the proposed treaty, an individual resident of the United States or Iceland is 

entitled to all treaty benefits. If, however, such an individual receives income as a nominee on 

behalf of a third-country resident, and thus is not the beneficial owner of the income, benefits 

may be denied. 

Governments

The proposed treaty provides that the United States and Iceland, and any political 

subdivision or local authority of either of the two countries, are entitled to all treaty benefits. 

Publicly traded companies and subsidiaries

A company that is a resident of the United States or Iceland is entitled to all treaty 

benefits if the principal class of its shares is regularly traded on one or more recognized stock 

exchanges (the “regular trading test”) and either (1) the company’s principal class of shares is 

primarily traded on a recognized stock exchange in its country of residence (the “primary trading 

test”), or (2) the company’s primary place of management and control is in its country of 

residence (the “management and control test”). Certain key elements of the regular trading test, 

primary trading test, and management and control test are described below. 

The term “principal class of shares” means the ordinary or common shares of a company 

representing the majority of the aggregate voting power and value of that company. If the 

company does not have a single class of ordinary or common shares representing the majority of 

the aggregate voting power and value, then the “principal class of shares” means that class or 

those classes of shares that in the aggregate represent a majority of the aggregate voting power 

and value of the company. 

The term “regularly traded” is not defined in the proposed treaty and therefore has the 

meaning it has under the laws of the relevant treaty country, usually the source country. In the 

United States, the term has the same meaning as it does under Treas. Reg. section 1.884-

5(d)(4)(i)(B). Based on that provision, the Technical Explanation states that a class of shares is 

regularly traded if (1) trades in the class of shares are made in more than de minimis quantities 
 

55 

on at least 60 days during the taxable year, and (2) the aggregate number of shares in the class 

traded during the year is at least 10 percent of the average number of shares outstanding during 

the year. The Technical Explanation notes that trading on one or more recognized stock 

exchanges may be aggregated for purposes of meeting the “regularly traded” requirement. 

The term “recognized stock exchange” means the NASDAQ System owned by the 

National Association of Securities Dealers, Inc.; any stock exchange registered with the U.S. 

Securities and Exchange Commission as a national securities exchange under the U.S. Securities 

Exchange Act of 1934; the Icelandic Stock Exchange; the stock exchanges of Amsterdam, 

Brussels, Copenhagen, Frankfurt, Hamburg, Helsinki, London, Oslo, Paris, Stockholm, Sydney, 

Tokyo, and Toronto; and any other stock exchange agreed upon by the competent authorities of 

the treaty countries. 

The term “primarily traded” is not defined in the proposed treaty and therefore has the 

meaning it has under the laws of the relevant treaty country, usually the source country. In the 

United States, the term has the same meaning as it does under Treas. Reg. section 1.884-5(d)(3). 

Based on that provision, the Technical Explanation states that stock of a corporation is primarily 

traded in the company’s country of residence if the number of shares in the company’s principal 

class of shares that are traded during the taxable year on all recognized stock exchanges in the 

treaty country of which the company is a resident exceeds the number of shares in the company’s 

principal class of shares that are traded during that year on established securities markets in any 

other single foreign country. 

A company the principal class of shares of which is regularly traded on a recognized 

stock exchange but which does not satisfy the primary trading test (that is, the requirement that a 

company’s principal class of shares be primarily traded on a recognized stock exchange in the 

company’s country of residence) may claim treaty benefits if it satisfies the management and 

control test—that is, if the company’s primary place of management and control is in the treaty 

country of which it is a resident. A company’s primary place of management and control is 

located in the treaty country in which the company is a resident only if the executive officers and 

senior management employees exercise day-to-day responsibility for more of the strategic, 

financial, and operational policy decision making for the company (including direct and indirect 

subsidiaries) in that country than in the other treaty country or any third country, and if the staff 

that support the management in making those decisions are also based in that residence country. 

The Technical Explanation notes that the management and control test should be 

distinguished from the “place of effective management” test used by many countries and in the 

OECD Model treaty to establish residence. The place of effective management test often has 

been interpreted to mean the place where the board of directors meets. Under the proposed 

treaty, by contrast, the management and control test looks to where day-to-day responsibility for 

the management of the company (and its subsidiaries) is exercised. 

A company that does not satisfy the regular trading test and either the primary trading test 

or the management and control test (because, for example, its shares are not publicly traded) may 

be entitled to treaty benefits if shares representing at least 50 percent of its aggregate voting 

power and value are owned, directly or indirectly, by five or fewer companies that satisfy the 

regular trading test and either the primary trading test or the management and control test, 
 

56 

provided that, in the case of indirect ownership, each intermediate owner is a resident of the 

United States or Iceland. This rule allows certain subsidiaries of publicly traded companies to be 

eligible for all benefits under the treaty. 

Pension schemes and employee benefits organizations

A pension scheme or employee benefits organization is entitled to all the benefits of the 

proposed treaty if more than 50 percent of the organization’s beneficiaries, members, or 

participants are individuals resident in either the United States or Iceland. According to the 

Technical Explanation, for purposes of this provision, the term “beneficiaries” should be 

understood to refer to the persons receiving benefits from the organization. 

Tax-exempt organizations

An organization established in its country of residence exclusively for religious, 

charitable, scientific, artistic, cultural, or educational purposes is entitled to treaty benefits 

notwithstanding that all or part of its income or gains may be exempt from tax under the 

domestic law of that country. The Technical Explanation notes that a tax-exempt organization 

other than a pension scheme or employee benefits organization qualifies for benefits without 

regard to the residence of its beneficiaries or members. 

Ownership and base erosion tests

An entity that is a resident of one of the treaty countries is entitled to treaty benefits if it 

satisfies both an ownership test and a base erosion test. 

An entity that is a resident of a treaty country satisfies the ownership test if on at least 

half the days of the taxable year at least 50 percent of each class of the entity’s shares or other 

beneficial interests are owned, directly or indirectly, by residents of that treaty country who are 

entitled to treaty benefits under the limitation-on-benefits article as individuals, governments, 

parent companies that meet the public company test, pension schemes or employee benefits 

organizations, or tax-exempt organizations. In the case of indirect ownership, each intermediate 

owner must be a resident of the same treaty country as the entity seeking to satisfy the ownership 

test. 

The base erosion test is satisfied only if less than 50 percent of the person’s gross income 

for the taxable year, as determined in that person’s country of residence, is paid or accrued, 

directly or indirectly, in the form of payments deductible in the person’s country of residence, to 

persons who are not residents of either treaty country entitled to treaty benefits under this article 

as individuals, governments, parent companies that meet the public company test, pension 

schemes or employee benefits organizations, or tax-exempt organizations. Arm’s-length 

payments made in the ordinary course of business for services or tangible property, and certain 

payments in respect of financial obligations to a bank, do not count against the entity in 

determining whether the 50-percent threshold is reached. 

The Technical Explanation states that trusts may be entitled to the benefits of this 

provision if they are treated as residents under Article 4 (Resident) and they otherwise satisfy the 

ownership and base erosion tests. 
 

57 

Derivative benefits rule

The proposed treaty includes derivative benefits rules that are generally intended to allow 

a treaty-country company treaty benefits for an item of income if the company’s owners would 

have been entitled to the same benefits for the income had those owners derived the income 

directly. Under these derivative benefits rules, a treaty-country company is eligible for treaty 

benefits for an item of income only if the company satisfies both an ownership requirement and a 

base erosion requirement. 

A company satisfies the ownership requirement if shares representing at least 95 percent 

of the company’s aggregate voting power and value are owned directly or indirectly by seven or 

fewer persons who are residents of European Union member states, European Economic Area 

states, North American Free Trade Agreement parties, or European Free Trade Agreement 

parties (together, “qualifying countries”) and satisfy either of two criteria described below. 

The first criterion includes two requirements. First, the person must be entitled to all 

treaty benefits under a comprehensive income tax treaty between a qualifying country and the 

country from which the benefits of the proposed treaty are being claimed (an “applicable 

treaty”), and this entitlement to treaty benefits must result from satisfaction of limitation-onbenefits provisions analogous to the proposed treaty’s rules, described above, for individuals, 

governments, parent companies that meet the public company test, pension schemes or employee 

benefits organizations, and tax-exempt organizations. If the applicable treaty does not include a 

comprehensive limitation-on-benefits article, this first requirement is satisfied only if the person 

would meet the proposed treaty’s requirements for entitlement to treaty benefits as an individual, 

a government, a parent company that meets the public company test, a pension scheme or 

employee benefits organization, or a tax-exempt organization. Second, for income from 

dividends, interest, or royalties, the person must be entitled under an applicable treaty to a rate of 

tax on that income that is at least as low as the rate applicable under the proposed treaty (the “tax 

rate test”). 

The Technical Explanation gives the following example to illustrate the operation of the 

tax rate test. A U.S. company is wholly owned by an Icelandic company that in turn is wholly 

owned by a Canadian company. Assume the Icelandic company otherwise satisfies the 

requirements of the five-percent rate dividend provision, and assume that if the Canadian 

company received a dividend directly from the U.S. company, the applicable dividend 

withholding tax rate under the U.S.-Canadian treaty would be five percent. Under these facts, 

the Canadian company would be a resident of a qualifying country under the rules described 

above because it would be entitled to a withholding tax rate at least as low as the applicable rate 

(five percent) under the proposed treaty. 

A person satisfies the second criterion of the ownership requirement if the person is a 

U.S. or Icelandic resident entitled to treaty benefits under one of the rules described previously 

for individuals, governments, parent companies that meet the public company test, pension 

schemes or employee benefits organizations, or tax-exempt organizations. Under this rule, 

according to the Technical Explanation, an Icelandic individual qualifies with respect to an item 

of income received by another treaty country resident regardless of whether the individual would 

have been entitled to receive the same benefits if it had received the income directly. The 
 

58 

Technical Explanation states that this criterion was included to clarify that ownership by certain 

residents of a treaty country does not disqualify a U.S. or Icelandic company from treaty benefits 

under the derivative benefits rules. If, for example, 90 percent of a Icelandic company is owned 

by five companies that are residents of European Union member states and that satisfy the first 

criterion described previously (the applicable treaty rules and the tax rate test), and 10 percent of 

the Icelandic company is owned by a U.S. or a Icelandic individual, the Icelandic company still 

can satisfy the requirements of the ownership test of the derivative benefits rules. 

A company satisfies the base erosion requirement for an item of income only if, in the 

taxable year in which the income item arises, the amount of the deductible payments or accruals 

the company makes, directly or indirectly, to persons who are not residents of qualifying 

countries is less than 50 percent of the company’s gross income for the year, as determined in the 

company’s country of residence. 

Active business test

Under the proposed treaty, a resident of one treaty country is entitled to treaty benefits 

with respect to an item of income derived from the other country if (1) the resident is engaged in 

the active conduct of a trade or business in its residence country, and (2) the income from the 

other country is derived in connection with or is incidental to that trade or business. The 

proposed treaty provides that the business of making or managing investments for the resident’s 

own account does not constitute an active trade or business unless the business is banking, 

insurance, or securities activities carried on by a bank, an insurance company, or a registered 

securities dealer. 

The term “trade or business” is not defined in the proposed treaty. According to the 

Technical Explanation, under paragraph 2 of Article 3 (General Definitions) of the proposed 

treaty, when determining whether a resident of Iceland is entitled to the benefits of the proposed 

treaty under the active business test with respect to an item of income derived from sources 

within the United States, the United States will ascribe to this term the meaning that it has under 

the laws of the United States. Accordingly, the Technical Explanation states, the U.S. competent 

authority will refer to the regulations issued under section 367(a) for the definition of the term 

“trade or business.” In general, a trade or business will be considered to be a specific unified 

group of activities that constitute or could constitute an independent economic enterprise carried 

on for profit. Furthermore, a corporation generally will be considered to carry on a trade or 

business only if the officers and employees of the corporation conduct substantial managerial 

and operational activities. 

The Technical Explanation elaborates on the requirement that an item of income from the 

source country be derived “in connection with” or be “incidental to” the resident’s trade or 

business in its residence country. The Technical Explanation provides that an item of income is 

derived in connection with a trade or business if the income-producing activity in the source 

country is a line of business that “forms a part of” or is “complementary to” the trade or business 

conducted in the residence country by the income recipient. 

According to the Technical Explanation, a business activity generally will be considered 

to form part of a business activity conducted in the country of source if the two activities involve 
 

59 

the design, manufacture, or sale of the same products or type of products, or the provision of 

similar services. The line of business in the country of residence may be upstream, downstream, 

or parallel to the activity conducted in the country of source. Thus, the line of business may 

provide inputs for a manufacturing process that occurs in the source country, may sell the output 

of that manufacturing process, or simply may sell the same sorts of products that are being sold 

by the trade or business carried on in the country of source. 

The Technical Explanation states that for two activities to be considered to be 

“complementary,” the activities need not relate to the same types of products or services but 

should be part of the same overall industry and should be related in the sense that the success or 

failure of one activity will tend to result in success or failure for the other. Where more than one 

trade or business is conducted in the country of source and only one of the trades or businesses 

forms a part of or is complementary to a trade or business conducted in the country of residence, 

it is necessary, according to the Technical Explanation, to identify the trade or business to which 

an item of income is attributable. Royalties generally are considered to be derived in connection 

with the trade or business to which the underlying intangible property is attributable. Dividends 

are deemed to be derived first out of earnings and profits of the treaty-benefited trade or business 

and then out of other earnings and profits. Interest income may be allocated under any 

reasonable method consistently applied. A method that conforms to U.S. principles for expense 

allocation will be considered a reasonable method. 

The Technical Explanation further states that an item of income derived from the country 

of source is “incidental to” the trade or business carried on in the country of residence if 

production of the item facilitates the conduct of the trade or business in the country of residence. 

An example of incidental income is the temporary investment of working capital of a person in 

the country of residence in securities issued by persons in the country of source. 

The proposed treaty provides that if a resident of a treaty country or any of its associated 

enterprises carries on a trade or business activity in the other country that gives rise to an item of 

income, the active business test applies to the item of income only if the trade or business 

activity in the residence country is substantial in relation to the trade or business activity in the 

source country. The determination is made separately for each item of income derived from the 

source country. 

The Technical Explanation explains that the substantiality requirement is intended to 

prevent a narrow case of treaty-shopping abuses in which a company attempts to qualify for 

benefits by engaging in de minimis connected business activities in the treaty country in which it 

is resident (that is, activities that have little economic cost or effect with respect to the company 

business as a whole). The determination of substantiality is made based upon all the facts and 

circumstances and takes into account the comparative sizes of the trades or businesses in each 

treaty country, the nature of the activities performed in each country, and the relative 

contributions made to that trade or business in each country. 

The proposed treaty provides that, in determining whether a person is engaged in the 

active conduct of a trade or business in a treaty country, activities conducted by partnerships in 

which that person is a partner and activities conducted by persons “connected” to that first 

person are deemed to be conducted by that first person. A person is “connected” to another 
 

60 

person if one possesses at least 50 percent of the beneficial interest in the other (or, in the case of 

a company, at least 50 percent of the aggregate voting power and at least 50 percent of the 

aggregate value of the shares in the company or of the beneficial equity interest in the company), 

or another person possesses, directly or indirectly, that requisite interest in each of the two 

entities. A person is also considered to be connected to another if, based on all the relevant facts 

and circumstances, one has control of the other or both are under the control of the same person 

or persons. 

The triangular case

The proposed treaty provides a special anti-abuse rule that, according to the Technical 

Explanation, addresses an Icelandic resident’s use of the following structure to earn interest 

income from the United States. The Icelandic resident (who is otherwise qualified for benefits 

under this article) organizes a permanent establishment in a third country that imposes a low rate 

of tax on the income of the permanent establishment. The Icelandic resident then lends funds 

into the United States through the permanent establishment. The permanent establishment is an 

integral part of the Icelandic resident. Consequently, the interest income that the permanent 

establishment earns on the loan is entitled to exemption from U.S. withholding tax under the 

treaty. Under the tax treaty between Iceland and the third country, Iceland does not tax the 

income earned by the permanent establishment. Alternatively, Iceland may choose to exempt the 

income of the permanent establishment from Icelandic income tax. Consequently, the income is 

not taxed in Iceland or the United States, and is only lightly taxed in the third country. 

Under the proposed treaty, the United States may impose withholding tax on the interest 

payments if the combined tax actually paid on the income in Iceland and the third country is less 

than 60 percent of the tax that would have been payable to Iceland if the income were earned in 

Iceland and were not attributable to the permanent establishment in the third country. 

Although the example in the Technical Explanation involves interest income, the 

triangular provision also applies to all types of income. Any dividends, interest, or royalties to 

which the provision applies may be subject to a maximum withholding tax rate of 15 percent. 

Any other income to which the provision applies is subject to tax under the domestic law of the 

source state, notwithstanding any other provision of the proposed treaty. 

According to the Technical Explanation, the principles of the U.S. subpart F rules are 

employed to determine whether the profits of the permanent establishment are subject to an 

effective rate of tax that is above the specified threshold. 

The triangular provision does not apply to royalties that are received as compensation for 

the use of, or the right to use, intangible property produced or developed by the permanent 

establishment itself. In the case of any other income, the triangular provision does not apply if 

that income is derived in connection with, or is incidental to, the active conduct of a trade or 

business carried on by the permanent establishment in the third country (other than the business 

of making, managing, or holding investments for the person’s own account, unless the business 

is banking or securities activities carried on by a bank or a registered securities dealer). 
 

61 

The triangular provision applies reciprocally. However, the United States does not 

exempt the income of a third-country permanent establishment of a U.S. resident from U.S. tax, 

either by statute or by treaty. 

Grant of treaty benefits by the competent authority

Under the proposed treaty, a resident of a treaty country that is not otherwise entitled to 

treaty benefits under this article may nonetheless be granted treaty benefits if the competent 

authority of the other treaty country determines that the establishment, acquisition, or 

maintenance of the resident and the conduct of its operations did not have as one of its principal 

purposes the obtaining of benefits under the treaty. 

According to the Technical Explanation, the competent authority’s discretion under this 

provision is broad. The competent authority, for example, may grant all treaty benefits, may 

grant benefits only with respect to a particular item of income, and may set time limits on the 

duration of any relief granted. The competent authority of the source country is required to 

consult with the competent authority of the residence country before denying treaty benefits 

under this provision. 

Shares with a disproportionate part of a company’s income

Under the proposed treaty, a special rule applies in cases in which a company that is 

resident in one treaty country, or a company that controls such a company directly or indirectly, 

has outstanding a class of shares subject to terms or other arrangements that entitle a shareholder 

to a larger portion of the company’s income in the other treaty country than that to which the 

shareholder would be entitled in the absence of those terms or arrangements (“the 

disproportionate part of the income”). If more than 50 percent of those shares are owned by 

persons not entitled to treaty benefits under one of the rules described previously for individuals, 

governments, publicly traded companies and subsidiaries, pension schemes or employee benefits 

organizations, tax-exempt organizations, or entities that satisfy the ownership and base erosion 

tests, then treaty benefits do not apply with respect to the disproportionate part of the income. 

Article 22. Relief From Double Taxation

Internal taxation rules

United States

The United States taxes the worldwide income of its citizens and residents. It attempts 

unilaterally to mitigate double taxation generally by allowing taxpayers to credit the foreign 

income taxes that they pay against U.S. tax imposed on their foreign-source income. An indirect 

or “deemed-paid” credit is also provided. Under this rule, a U.S. corporation that owns 10 

percent or more of the voting stock of a foreign corporation and that receives a dividend from the 

foreign corporation (or an inclusion of the foreign corporation's income) is deemed to have paid 

a portion of the foreign income taxes paid by the foreign corporation on its earnings. The taxes 

deemed paid by the U.S. corporation are included in its total foreign taxes paid for the year the 

dividend is received. 
 

62 

A fundamental premise of the foreign tax credit is that it may not offset U.S. tax on U.S.-

source income. Therefore, the foreign tax credit provisions limit the foreign taxes that a taxpayer 

may claim as credits for the year to the amount of the taxpayer’s U.S. tax liability attributable to 

its foreign-source income. The limitation is computed separately for “passive category income” 

and other income in order to prevent the crediting of foreign taxes on certain high-taxed foreignsource income against the U.S. tax on certain types of traditionally low-taxed foreign-source 

income. Other limitations may apply in determining the amount of foreign taxes that may be 

credited against the U.S. tax liability of a U.S. taxpayer. 

Iceland

Individuals and companies resident in Iceland generally are taxed on their worldwide 

income. In the absence of a treaty, relief from double taxation of foreign-source income 

generally is provided in the form of a tax credit. 

Proposed treaty

Overview

One of the principal purposes for entering into an income tax treaty is to limit double 

taxation of income earned by a resident of one of the countries that may be taxed by the other 

country. Unilateral efforts to limit double taxation are imperfect. Because of differences in rules 

as to when a person may be taxed on business income, a business may be taxed by two countries 

as if it were engaged in business in both countries. Also, a corporation or individual may be 

treated as a resident of more than one country and be taxed on a worldwide basis by both. 

Part of the double tax problem is addressed in other articles of the proposed treaty that 

limit the right of a source country to tax income. This article provides further relief where both 

Iceland and the United States still tax the same item of income. This article is not subject to the 

saving clause; the country of citizenship or residence will waive its overriding taxing jurisdiction 

to the extent that this article applies. 

U.S. tax relief for taxes paid to Iceland 

Paragraph 1 of Article 24 generally provides that the United States will allow a U.S. 

citizen or resident a foreign tax credit for the income taxes paid to Iceland, and will allow a U.S. 

corporation a deemed-paid credit when the U.S. corporation receives dividends from an Icelandic 

corporation in which the U.S. corporation owns 10 percent or more of the voting stock. The 

credit generally is to be computed in accordance with the provisions and subject to the 

limitations of U.S. law (as such law may be amended from time to time without changing the 

general principles of the proposed treaty provisions). This provision is similar to those found in 

the U.S. Model treaty and many U.S. tax treaties, and is consistent with U.S. law. 

The proposed treaty provides that the taxes referred to in paragraphs 3(a) and 4 of Article 

2 (Taxes Covered) will be considered income taxes for purposes of paragraph 1. The Technical 

Explanation states that this rule is based on the Treasury Department’s review of Iceland’s laws. 
 

63 

Subparagraph 2(a) contains a re-sourcing rule that applies for purposes of paragraph 1. 

Under subparagraph 2(a), an item of gross income (as determined under U.S. law) that is derived 

by a U.S. resident and that may be taxed by Iceland under the proposed treaty will be deemed to 

be income from sources in Iceland for U.S. foreign tax credit purposes. The Technical 

Explanation states that this re-sourcing rule is intended to ensure that a U.S. resident can obtain 

an appropriate amount of U.S. foreign tax credit for taxes paid to Iceland when the proposed 

treaty assigns to Iceland primary taxing jurisdiction over an item of gross income. 

 In the case of a U.S.-owned foreign corporation, section 904(g)(10) may apply for 

purposes of determining the U.S. foreign tax credit with respect to income subject to this resourcing rule. Section 904(g)(10) generally applies the foreign tax credit limitation described 

above separately to re-sourced income. Furthermore, because the re-sourcing rule applies to 

gross income, not net income, U.S. expense allocation and apportionment rules continue to apply 

to income resourced under subparagraph 2(a). 

Under subparagraph 2(b), the general re-sourcing rule described above does not apply in 

the case of certain gains. In particular, gains derived by an individual while the individual was a 

resident of the United States that are taxed by the United States in accordance with the proposed 

treaty, and that may also be taxed in Iceland solely by reason of paragraph 6 of Article 13 

(Capital Gains), are deemed to be gains from sources in the United States. Paragraph 6 allows 

Iceland to impose tax on gain derived by a U.S. resident from the sale of stock in an Iceland 

company if the individual was a resident of Iceland in the course of the five-year period 

preceding the sale of the stock. The Technical Explanation states that the provisions of 

subparagraph 2(b) ensure that the United States does not bear, from a foreign tax credit 

standpoint, the cost of Iceland’s expatriation tax. However, the taxes paid to Iceland are 

creditable income taxes for purposes of paragraph 1 of Article 24. Accordingly, subject to the 

limitations described above under “Internal taxation rules - United States,” an individual may 

claim a U.S. foreign tax credit for the taxes paid to Iceland. 

Iceland tax relief for taxes paid to the United States

Specific rules are provided in paragraph 3 under which Iceland, in imposing tax on its 

residents, provides relief for U.S. taxes paid by those residents. Subparagraph 3(a) provides that 

when a resident of Iceland derives income that, in accordance with the provisions of the 

proposed treaty, may be taxed in the United States, Iceland shall allow as a credit against 

Icelandic income taxes an amount equal to those taxes paid to the United States. 

Subparagraph 3(b) limits the credit against Icelandic taxes to those taxes that are 

attributable to the income that has been taxed by the United States. 

Subparagraph 3(c) provides that when a resident of Iceland derives income that, in 

accordance with the provisions of the proposed treaty, is taxable solely by the United States, 

Iceland shall allow a credit against Icelandic tax as limited in subparagraph 3(b). However, 

subparagraph 3(c) permits Iceland to include the income in the resident’s tax base. The 

Technical Explanation states that the rule is similar to U.S. domestic law, which permits credits 

for foreign taxes paid, while at the same time taxing residents on worldwide income. Finally, 

subparagraph 3(c) provides that for purposes of paragraph 3, the U.S. taxes referred to in 
 

64 

subparagraph 3(b) and paragraph 4 of Article 2 (Taxes Covered) are considered to be income 

taxes allowable as credits against Icelandic tax on income under paragraph 3 of Article 22. 

U.S. citizens who are resident in Iceland

Paragraph 4 provides special rules for the tax treatment of certain types of income 

derived by U.S. citizens who are residents of Iceland. U.S. citizens, regardless of residence, are 

subject to United States tax on their worldwide income. The U.S. tax on the income of a U.S. 

citizen who is a resident of Iceland may exceed the U.S. tax that may be imposed under the 

proposed treaty on the income if it were derived by a resident of Iceland who is not a U.S. 

citizen. The Technical Explanation states that the provisions of paragraph 4 ensure that Iceland 

does not bear the cost of U.S. taxation of its citizens who are residents of Iceland. 

Subparagraph 4(a) provides a special credit rule for Iceland that limits the amount of 

credit Iceland must allow a resident of Iceland. The rule applies to items of income that would 

be either exempt from U.S. tax or subject to reduced rates of U.S. tax under the provisions of the 

proposed treaty if they had been received by a resident of Iceland who is not a U.S. citizen. The 

tax credit allowed by Iceland under paragraph 4 with respect to such items need not exceed the 

U.S. tax that may be imposed under the proposed treaty, other than U.S. tax imposed solely by 

reason of the U.S. citizenship of the taxpayer under the provisions of the saving clause of 

paragraph 4 of Article 1 (General Scope). 

For example, if a U.S. citizen resident in Iceland receives portfolio dividends from 

sources within the United States, the foreign tax credit granted by Iceland would be limited to 15 

percent of the dividend – the U.S. tax that may be imposed under subparagraph 2(b) of Article 10 

(Dividends) – even if the shareholder is subject to U.S. net income tax because of his U.S. 

citizenship. With respect to interest income, Iceland would allow no foreign tax credit, because 

its residents are exempt from U.S. tax on interest income under the provisions of Articles 11 

(Interest). 

Subparagraph 4(b) eliminates the potential for double taxation that can arise because 

subparagraph 4(a) provides that Iceland need not provide full relief for the U.S. tax imposed on 

its citizens resident in Iceland. The subparagraph provides that the United States will credit the 

income tax paid or accrued to Iceland, after the application of subparagraph 4(a). It further 

provides that in allowing the credit of the taxes paid to Iceland, the United States will not reduce 

its tax below the amount that is creditable against Icelandic tax under subparagraph 4(a). 

Since the income described in subparagraph 4(a) generally will be U.S. source income, 

special rules are required to re-source some of the income to Iceland in order for a taxpayer to be 

able to credit the tax paid to Iceland. This re-sourcing is provided for in subparagraph 4(c), 

which deems the items of income referred to in subparagraph 4(a) to be from foreign sources to 

the extent necessary to avoid double taxation under subparagraph 4(b). 

The Technical Explanation contains examples illustrating the application of paragraph 4. 
 

65 

Relationship to other Articles

By virtue of subparagraph 5(a) of Article 1 (General Scope), Article 22 is not subject to 

the saving clause of paragraph 4 of Article 1. Thus, the United States will allow a credit to its 

citizens and residents in accordance with Article 22, even if such credit were to provide a benefit 

not available under the Code (such as the re-sourcing provided by paragraph 2 and subparagraph 

4(c)). 

Article 23. Non-Discrimination

The proposed treaty includes a comprehensive nondiscrimination article. The article is 

similar to the nondiscrimination article in the U.S. Model treaty and to provisions that have been 

included in other recent U.S. income tax treaties. 

In general, under the proposed treaty, neither treaty country is permitted to discriminate 

against nationals of the other country by imposing on those nationals more burdensome taxes 

than it would impose on its own comparably situated nationals in the same circumstances.43 Not 

all instances of differential treatment are discriminatory. Differential treatment is permissible in 

some instances under this rule on the basis of tax-relevant differences (for example, the fact that 

one person is subject to worldwide taxation in a treaty country and another person is not, or the 

fact that an item of income may be taxed at a later date in one person’s hands but not in another 

person’s hands). 

Under the proposed treaty, neither country may tax a permanent establishment of an 

enterprise of the other country less favorably than it taxes its own enterprises carrying on the 

same activities. 

As under the U.S. and OECD Model treaties, however, a treaty country is not obligated to 

grant residents of the other treaty country any personal allowances, reliefs, or reductions for tax 

purposes on account of civil status or family responsibilities that it grants to its own residents. 

Except in circumstances in which the anti-avoidance rules described in paragraph 1 of 

Article 9 (Associated Enterprises), paragraph 4 of Article 11 (Interest), or paragraph 6 of Article 

12 (Royalties) apply, interest, royalties, and other disbursements paid by an enterprise of a treaty 

country to a resident of the other treaty country must be deductible under the same conditions as 

if those amounts had been paid to a resident of the first treaty country. The Technical 

Explanation states that the exception relating to paragraph 4 of Article 11 (Interest) would 

include the denial or deferral of certain interest deductions under section 163(j) of the Code, thus 

allowing United States to apply its earnings stripping rules. 

Any debts of an enterprise of one treaty country to a resident of the other treaty country 

must, for purposes of determining the taxable capital of the enterprise, be deductible under the 

 43 A national of one treaty country may claim protection under this article even if the national is 

not a resident of either treaty country. For example, a U.S. citizen who is resident in a third country is 

entitled to the same treatment in Iceland as a comparably situated Icelandic national. 
 

66 

same conditions as if they had been owed to a resident of the first treaty country. According to 

the Technical Explanation, this rule, which applies in computing capital tax, is consistent with 

the nondiscrimination provisions generally because those provisions, in contrast with the general 

purpose of the treaty, which is to cover only income taxes, apply to all taxes levied in either 

treaty country. 

The nondiscrimination rules also apply to enterprises of one treaty country that are owned 

in whole or in part by one or more residents of the other treaty country. An enterprise of one 

treaty country the capital of which is wholly or partly owned or controlled, directly or indirectly, 

by one or more residents of the other treaty country may not be subjected in the first country to 

any taxation (or any connected requirement) that is more burdensome than the taxation (or 

connected requirements) that the first country imposes or may impose on other similar 

enterprises. As noted above, some differences in treatment may be justified on the basis of taxrelevant differences in circumstances between two enterprises. In this regard, the Technical 

Explanation provides examples of Code provisions that are understood by the two countries not 

to violate the nondiscrimination provision of the proposed treaty, including the rules that tax U.S. 

corporations making certain distributions to foreign shareholders in what would otherwise be 

nonrecognition transactions, the rules that impose a withholding tax on non-U.S. partners of a 

partnership, the rules that prevent foreign persons from owning stock in subchapter S 

corporations, and the rules that prevent foreign corporations from joining in filing consolidated 

returns with domestic corporations. 

The proposed treaty provides that nothing in the nondiscrimination article may be 

construed as preventing either of the countries from imposing a branch profits tax as described in 

paragraph 8 of Article 10 (Dividends). 

Notwithstanding the definition of taxes covered in Article 2 (Taxes Covered), Article 23 

applies to taxes of every kind and description imposed by either country, or any political 

subdivision or local authority of that treaty country. The Technical Explanation states that 

customs duties are not regarded as taxes for this purpose. 

The saving clause does not apply to the nondiscrimination article. Thus, a U.S. citizen 

who is a resident of Iceland may claim benefits in the United States under Article 23. 

The protocol to the proposed treaty states that Article 23 (and Article 7 (Business 

Profits)) do not prevent Iceland from taxing permanent establishments of U.S. insurance 

companies in accordance with Article 70, paragraph 2, section 3 of the Icelandic Tax Code and 

do not prevent the United States from taxing the permanent establishments of Icelandic insurance 

companies in accordance with section 842(b) of the Code (which prescribes rules for the 

minimum net investment income treated as being effectively connected with the conduct of an 

insurance business in the United States). 

Article 24. Mutual Agreement Procedure

The mutual agreement provision permits taxpayers to bring to the attention of the 

competent authorities problems that may arise under the proposed treaty and authorizes the 

competent authorities of the two countries to cooperate to resolve disputes, clarify issues, and 
 

67 

address cases of double taxation not provided for in the proposed treaty. The saving clause of 

the proposed treaty does not apply to the mutual agreement procedure. Consequently, the United 

States may apply to a U.S. citizen or resident rules and definitions agreed to by the competent 

authorities under the mutual agreement procedure even if those rules and definitions differ from 

comparable provisions of the Code. 

Under Article 24, a person who considers that the actions of one or both of the treaty 

countries cause that person to be subject to tax in a manner not in accordance with the provisions 

of the proposed treaty may, irrespective of internal law remedies or time limits for refund claims, 

present a case to the competent authority of either treaty country. Unlike the OECD Model 

treaty, the proposed treaty provides no time limit for when a case must be brought. This rule is 

the same as the rule in the U.S. Model treaty but, according to the Technical Explanation, is 

more generous than the rule in most U.S. tax treaties. Under most treaties, a taxpayer may bring 

a case only to the competent authority of the taxpayer’s country of residence, citizenship, or 

nationality. The Technical Explanation notes that the more generous rule of the proposed treaty 

allows a U.S. permanent establishment of a corporation that is a resident of Iceland to ask the 

U.S. competent authority for assistance if it is subject to inconsistent treatment in the United 

States and Iceland. 

The Technical Explanation notes that typical cases brought under the mutual agreement 

procedure will involve economic double taxation arising from transfer pricing adjustments but 

that other types of cases also may be brought. The Technical Explanation gives as an example a 

taxpayer who has received income that the source country has determined is deferred 

compensation and therefore is taxable in that country but which the taxpayer believes is a 

pension taxable only in the taxpayer’s country of residence. 

The proposed treaty provides that if an objection presented to a competent authority 

appears to be justified and that competent authority is not itself able to arrive at a satisfactory 

solution, that competent authority must endeavor to resolve the case by mutual agreement with 

the competent authority of the other treaty country, with a view to the avoidance of taxation that 

is not in accordance with the proposed treaty. The proposed treaty provides that any agreement 

reached will be implemented notwithstanding any time limits or other procedural limitations in 

the domestic law of either treaty country (for example, a country’s applicable statute of 

limitations). The Technical Explanation notes that if a taxpayer has entered into a closing 

agreement with the United States before bringing a case to the competent authorities, the U.S. 

competent authority will do nothing other than endeavor to obtain a correlative adjustment from 

Iceland. Procedural limitations can be overridden, according to the Technical Explanation, only 

for the purpose of making refunds and not to impose additional tax. 

The competent authorities of the treaty countries are to endeavor to resolve by mutual 

agreement any difficulties or doubts arising as to the interpretation or application of the proposed 

treaty. In particular, the competent authorities may agree to: (1) the same attribution of income, 

deductions, credits, or allowances of an enterprise of one treaty country to the enterprise’s 

permanent establishment situated in the other country; (2) the same allocation of income, 

deductions, credits, or allowances between persons; (3) the same characterization of particular 

items of income, including the same characterization of income that is assimilated to income 

from shares by the tax laws of one treaty country and that is treated as a different class of income 
 

68 

in the other treaty country; (4) the same characterization of persons; (5) the same application of 

source rules with respect to particular items of income; (6) a common meaning of a term; and (7) 

the application of the provisions of each treaty country’s domestic law regarding penalties, fines, 

and interest in a manner consistent with the purposes of the proposed treaty. The Technical 

Explanation clarifies that this list is a nonexhaustive list of examples of the kinds of matters 

about which the competent authorities may reach agreement. The list therefore does not grant 

any authority that is not otherwise provided by the rule that the competent authorities are to 

endeavor to resolve by mutual agreement any difficulties or doubts about the interpretation or 

application of the proposed treaty. 

The proposed treaty provides that the competent authorities may consult together for the 

elimination of double taxation in cases not provided for in the proposed treaty. 

The proposed treaty authorizes the competent authorities to communicate with each other 

directly for purposes of reaching an agreement in the sense of this mutual agreement article. The 

Technical Explanation states that this provision makes clear that the competent authorities may 

communicate without going through diplomatic channels. 

The Technical Explanation states that even after the proposed treaty has been terminated, 

a taxpayer may bring to the competent authorities a case involving a year for which the proposed 

treaty was in force. 

The Technical Explanation addresses cases involving the taxing jurisdictions of more 

than two countries. The example given is where a parent corporation resident in country A 

engages in transactions with its subsidiaries in countries B and C. The Technical Explanation 

notes that if there is a complete network of treaties among the three countries, the competent 

authorities of those countries should be able to agree on a three-sided solution to a problem. 

A person may seek relief under the mutual agreement procedure even if the person is not 

generally entitled to benefits under the limitation on benefits rules of the proposed treaty. 

Article 25. Exchange of Information and Administrative Assistance

The proposed treaty generally provides that the two competent authorities will exchange 

such information as is relevant in carrying out the provisions of the proposed treaty or in carrying 

out the provisions of the domestic laws of the two treaty countries concerning all taxes of any 

kind imposed by a treaty country. The rules described below are broadly similar to the 

information exchange and administrative assistance rules in the U.S. Model treaty. 

This exchange of information is not restricted by paragraph 1 of Article 1 (General 

Scope). Accordingly, information may about persons who are residents of neither Iceland nor 

the United States may be requested and provided under this article. For example, according to 

the Technical Explanation, if a third-country resident has an Icelandic bank account and the U.S. 

IRS believes that funds in the account should have been, but have not been, reported to the IRS, 

the U.S. competent authority may request information from Iceland about the bank account even 

though the owner of the account is not the taxpayer under examination. 
 

69 

Exchange of information also is not restricted by Article 2 (Taxes Covered). The 

competent authorities may exchange information relating to, for example, U.S. estate and gift 

taxes, U.S. excise taxes, and Icelandic value added taxes. 

The proposed treaty provides that information exchange relating to each treaty country’s 

domestic law is authorized to the extent that taxation under that law is not contrary to the 

proposed treaty. According to the Technical Explanation, the competent authority of one treaty 

country may request information about a transaction from the competent authority of another 

treaty country even if the transaction to which the information relates is a purely domestic 

transaction in the requested country and information exchange about the transaction would not 

be undertaken to carry out the proposed treaty. As an example, the Technical Explanation states 

(referencing the OECD Model treaty) that if a U.S. company and an Icelandic company transact 

with one another through a company resident in a third country that has no treaty with the United 

States or Iceland, the U.S. and Icelandic competent authorities may, to enforce their internal 

rules, exchange information about prices their resident companies paid in their transactions with 

the third-country company. 

The proposed treaty provides that exchange of information may include information 

relating to the assessment or collection of, the enforcement or prosecution in respect of, or the 

determination of appeals in relation to, the taxes covered by the proposed treaty. Consequently, 

the competent authorities may exchange information about collection cases, cases under civil 

examination or criminal investigation, and cases being prosecuted. 

Any information exchanged under the proposed treaty must be treated as secret in the 

same manner as information obtained under the domestic laws of the treaty country receiving the 

information. The exchanged information may be disclosed only to persons or authorities 

(including courts and administrative bodies) involved in the assessment, collection, or 

administration of, the enforcement or prosecution in respect of, or the determination of appeals in 

relation to, the taxes to which the proposed treaty applies, or to persons or authorities engaged in 

the oversight of those taxes (for example, according to the Technical Explanation, the tax-writing 

committees of Congress and the General Accounting Office). The persons or authorities 

receiving information must use the information only in the performance of their official roles. 

Exchanged information may be disclosed in public court proceedings or in judicial decisions. 

If information is requested by a treaty country in accordance with this article, the 

proposed treaty provides that the requested treaty country must obtain the information in the 

same manner and to the same extent as if the tax of the requesting country were the tax of the 

requested country and were being imposed by that country, notwithstanding that the requested 

country may not need the information at that time for purposes of administering its own tax 

rules. According to the Technical Explanation, this rule clarifies that the limitations on 

information exchange described below do not prevent a treaty country from requesting 

information from a bank or a fiduciary that the treaty country does not need for its own tax 

purposes. 

As is true under the U.S. Model treaty and the OECD Model treaty, under the proposed 

treaty a country is not required to carry out administrative measures at variance with the laws and 

administrative practice of either treaty country; to supply information that is not obtainable under 
 

70 

the laws or in the normal administrative practice of either treaty country; or to supply 

information that would disclose any trade, business, industrial, commercial, or professional 

secret or trade process, or information the disclosure of which would be contrary to public 

policy. The Technical Explanation notes, however, that if a treaty country is asked to provide 

information, it should provide the information even if its own statute of limitations period has 

expired for the issue to which the information relates. According to the Technical Explanation, 

the statute of limitations of the treaty country making the request should govern. The Technical 

Explanation also states that even if the limitations on information exchange mean that a treaty 

country is not obligated to supply information in response to a request from the other treaty 

country, the requested country may choose to supply the information if doing so does not violate 

its internal law. 

The proposed treaty provides that if specifically requested by the competent authority of 

a treaty country, the competent authority of the other treaty country must provide information 

under this article in the form of depositions of witnesses and authenticated copies of unedited 

original documents (including books, papers, statements, records, accounts, and writings), to the 

same extent such depositions and documents can be obtained under the laws and administrative 

practices of the requested country with respect to its own taxes. 

Under the exchange of information rules, each treaty country must endeavor to collect on 

behalf of the other treaty country such amounts as may be necessary to ensure that treaty relief 

from taxation otherwise imposed by the other treaty does not inure to the benefit of persons not 

entitled to relief. The Technical Explanation provides the following example. If a U.S. payor of 

a portfolio dividend receives an IRS Form W-8BEN from the recipient of the dividend, the payor 

is permitted to withhold at the reduced treaty rate of 15 percent. If, however, the recipient is 

merely acting as a nominee of a third-country resident, the rule just described obligates Iceland 

to withhold and remit to the United States the additional tax that the U.S. payor should have 

collected. Neither treaty country, however, is obligated to carry out administrative measures that 

would be contrary to its sovereignty, security, or public policy. 

The proposed treaty provides that if a competent authority of a treaty country intends to 

send officials to the other treaty country to interview individuals or examine books and records 

with the consent of the persons being examined, that competent authority must notify the other 

treaty country’s competent authority of its intent. 

Under the protocol to the proposed treaty, the powers of each treaty country’s competent 

authority to obtain information include the ability to obtain information held by financial 

institutions, nominees, or persons acting in agency or fiduciary capacities. This power does not 

encompass obtaining information that would reveal confidential communications between a 

client and an attorney, solicitor, or other legal representative, where the client seeks legal advice. 

The protocol also provides that the competent authorities have the power to obtain information 

about the ownership of legal persons. The protocol states that the competent authorities are able 

to exchange the information described in the protocol in accordance with the rules in Article 25. 

According to the Technical Explanation, the protocol prevents a treaty country from relying on 

the limitation on information exchange described above to argue that its domestic bank secrecy 

laws (or similar rules) override its general obligation to provide information. 
 

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Article 26. Members of Diplomatic Missions and Consular Posts

The proposed treaty contains the rule (also found in the U.S. Model treaty, the present 

treaty, and other U.S. tax treaties) that its provisions do not affect the fiscal privileges of 

members of diplomatic missions or consular posts under the general rules of international law or 

under the provisions of special agreements. Accordingly, the proposed treaty will not preempt 

the exemption from tax that a host country may grant to the salary of diplomatic officials of the 

other country. The saving clause is not taken into account in the application of this article to host 

country residents (i.e., persons who are resident for purposes of the treaty) who are neither 

citizens nor lawful permanent residents (i.e., permanently resident for immigration law purposes) 

of the host country. Thus, for example, Icelandic diplomats who are considered residents of the 

United States for purposes of the treaty (but not for purposes of U.S. immigration law) are not 

made subject to U.S. tax by the proposed treaty. 

Article 27. Entry into Force

The proposed treaty provides that the treaty is subject to ratification in accordance with 

the applicable procedures of each treaty country. Each treaty country is to notify the other in 

writing, through diplomatic channels, when it has completed the required procedures. Generally, 

the proposed treaty will enter into force on the date of the later of the notifications made through 

diplomatic channels regarding the completion of the required ratification procedures. The 

Technical Explanation clarifies the rule, stating the relevant date is the date of the later notice, 

and not the date on which the notice is received by the other treaty country. 

With respect to withholding taxes, the provisions of the proposed treaty will have effect 

for amounts paid or credited on or after the first day of January in the first calendar following the 

year in which the proposed treaty enters into force. Thus, if the treaty enters into force on 

September 15, 2008, the withholding tax provisions have effect with respect to amounts paid or 

credited on or after January 1, 2009. Similarly, with respect to other taxes, the provisions of the 

proposed treaty will also have effect for taxes chargeable to tax periods beginning on or after the 

first day of January next following the date on which the proposed treaty enters into force. 

The proposed treaty provides that the present treaty generally ceases to have effect with 

respect to any tax or exchange of information as of the date the proposed treaty takes effect. 

However, taxpayers may elect to temporarily continue to claim benefits under the present treaty 

with respect to a period after the proposed treaty takes effect if they would have been entitled to 

greater benefits under the present treaty. For such a taxpayer, the present treaty would continue 

to have effect, in its entirety, for a 12-month period from the date on which the provisions of the 

proposed treaty would otherwise take effect. In addition, teachers are granted a special 

grandfather provision. Pursuant to the grandfather clause, any individual that is entitled to 

benefits under Article 21 (Teachers) of the present treaty at the time the proposed treaty enters 

into force will continue to be entitled to the benefits available under the present treaty as if that 

treaty were still in force. The grandfather clause lasts as long as such individual would have 

been entitled to the previously existing benefits. 
 

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Article 28. Termination

This article provides that the proposed treaty is to remain in effect indefinitely, unless 

terminated by one of the treaty countries. The treaty may be terminated at any time by giving 

notice, through the appropriate diplomatic channels, at least six months in advance before the 

end of any calendar year. If notice of termination is given, the provisions of the treaty with 

respect to withholding at the source will cease to have effect on January 1 of the next calendar 

year. Similarly, for other taxes, the treaty will cease to have effect for taxes chargeable with 

respect to the tax periods commencing on or after January 1 of the next calendar year. For 

example, if notice of termination is given on May 1, 2015, then provisions of the treaty with 

respect to withholding at source will cease to have effect on January 1, 2016. For calendar year 

companies, the treaty will cease to have effect for taxes chargeable to the tax period commencing 

January 1, 2016. However, for any company with a November 30 fiscal year end, the treaty will 

cease to have effect for taxes chargeable to the tax period commencing December 1, 2016. 
 

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VI. DISCUSSION 

A. Students and Trainees 

Treatment under proposed treaty

Under the proposed treaty, an individual resident of one treaty country who visits the other 

treaty country (“host country”) will be exempt from income tax in the host country on certain 

payments received if the primary purpose of the visit is: (1) to study at a university or other 

recognized educational institution in the host country; (2) to secure training required to qualify the 

individual to practice a profession or professional specialty; or (3) to study or perform research as the 

recipient of a grant, allowance, or award from a governmental, religious, charitable, scientific, 

literary, or educational organization.

With respect to students, the exempt payments are limited to those payments the 

individual receives for his or her maintenance, education, study, research, and training that come 

from sources abroad; grants, allowances, or awards; and income from personal services 

performed in the host country up to a limit of $9,000 or its Icelandic kronur equivalent. The 

exemption from income tax in the host country applies only for a period of five years from the 

time the visitor first arrives in the host country. 

With respect to trainees, the individual must be a resident of one treaty country and 

temporarily present in the host country as an employee of, or under contract with, a resident of 

the first treaty country, and the primary purpose of the visit must be either to acquire technical, 

professional, or business experience from a person other than the employer or a person related to 

the employer or to study at a university or other recognized educational institution in the host 

country. The proposed treaty provides that such individuals are exempt from host country 

taxation on up to $9,000 (or its Icelandic kronur equivalent) in personal services income for a 

period of up to one year. 

With respect to an individual resident of treaty country who visits the host country as a 

participant of a host-country government-sponsored program of training, research, or study, the 

individual will be exempt from host country taxation on up to $9,000 (or its Icelandic kronur 

equivalent) of income from personal services in respect of training, research, or study performed 

in the host country. To qualify for this exemption, the individual cannot be temporarily resident 

in the host country for more than one year. 

Issues

The proposed treaty generally has the effect of exempting certain payments from the 

income tax of both treaty countries. The exempt payments are those arising outside the host 

country that are received for the maintenance, education, and training of full-time students and 

full-time trainees as visitors from one treaty country to the other. This exemption conforms to 

the U.S. Model treaty and the OECD Model treaty provisions. Under the proposed treaty, fulltime students and trainees may also earn up to $9,000 U.S. dollars or its Icelandic kronur 

equivalent annually in tax-free personal services income. This personal service income 

exemption is similar to a provision in the U.S. Model treaty but departs from the OECD Model 
 

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treaty. Under section 911, a U.S. citizen or resident may elect to exclude $87,600 of non-U.S. 

source earned income attributable to personal services performed by the citizen or resident.44 

Section 911 in conjunction with the proposed treaty provision allows a U.S. student studying in 

Iceland to receive remuneration of up to $9,000 of income from personal services tax free. 

Similarly, if Iceland exempts labor income earned abroad from Icelandic tax, an Icelandic 

student studying in the United States could receive up to $9,000 of income from personal 

services tax free. By enabling a student to earn some income tax free, this provision generally 

would have the effect of reducing the cost of education and training received by visitors, which may 

encourage individuals to consider study abroad in the other treaty country. Such cross-border 

visits by students and trainees may foster the advancement of knowledge and redound to the 

benefit of residents of both countries. 

In the case of business trainees, the proposed treaty limits the exemption for such 

payments to a period of one year or less. By potentially subjecting such payments made beyond 

those received during the first 12 months of a visit to host country income tax, the cost for crossborder visitors of engaging in such longer duration training programs would be increased. This 

increased cost may discourage visitors to such programs in either country. It could be argued 

that the training of a business trainee relates primarily to specific job skills of value to the 

individual or the individual’s employer rather than enhancing general knowledge and crossborder understanding, as may be the case in the education of a full-time student. This could 

provide a rationale for providing more open-ended treaty benefits in the case of students as 

opposed to business trainees. However, this rationale raises a question as to why training 

requiring one year or less is preferred to training that requires a longer visit to the host country. 

As such, the proposed treaty would favor certain types of training arrangements over others. The 

OECD Model treaty does not limit the duration of exemption for payments for maintenance, 

education, and training for business trainees; the U.S. Model treaty limits the exemption to a 

period not exceeding one year. 

 44 The $87,600 exemption amount for 2008 is indexed for inflation. Code sec. 911(b)(2)(D); 

Rev. Proc. 2007-66, sec. 3.30, 2007-45 I.R.B. 970. 
 

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B. Limitation on Benefits 

In general

The proposed treaty includes limitation-on-benefits rules that are similar to the limitationon-benefits rules in other recent U.S. income tax treaties; in the proposed treaty with Bulgaria 

and the proposed protocol with Canada; and in the U.S. Model treaty. These rules are intended 

to prevent the indirect use of the U.S.-Iceland income tax treaty by persons who are not entitled 

to its benefits by reason of residence in the United States or Iceland. 

When a resident of one country derives income from another country, the internal tax 

rules of the two countries may cause that income to be taxed in both countries. One purpose of a 

bilateral income tax treaty is to allocate taxing rights for cross-border income and thereby to 

prevent double taxation of residents of the treaty countries. Although a bilateral income tax 

treaty is intended to apply only to residents of the two treaty countries, residents of third 

countries may attempt to benefit from a treaty by engaging in a practice known as “treaty 

shopping.” Treaty shopping may involve investing in one treaty country through an entity 

organized in the other treaty country to obtain the benefits of the treaty, or engaging in incomestripping transactions with a treaty-country resident. Limitation-on-benefits provisions are 

intended to deny treaty benefits in certain cases of treaty shopping. 

The present treaty between the United States and Iceland is one of only eight U.S. income 

tax treaties that do not include any limitation-on-benefits rules. Three of those eight treaties, 

including the treaties with Iceland, Hungary, and Poland, include provisions providing for 

complete exemption from withholding on interest payments from one treaty country to the other 

treaty country. Consequently, those three treaties may present attractive opportunities for treaty 

shopping. In fact, a November 2007 report prepared by the Treasury Department at the request 

of the U.S. Congress suggests that the income tax treaties with Hungary and Iceland have 

increasingly been used for treaty-shopping purposes as the United States adopted modern 

limitation-on-benefits provisions in its other treaties.45 With its inclusion of modern limitationon-benefits rules, the proposed treaty represents a significant opportunity to eliminate a treatyshopping opportunity. Nevertheless, the Committee may wish to inquire of the Treasury 

Department as to its plans to address the remaining U.S. income tax treaties that do not include 

limitation-on-benefits provisions, particularly Hungary and Poland. 

 45 Department of the Treasury, Report to the Congress on Earnings Stripping, Transfer Pricing 

and U.S. Income Tax Treaties (Nov. 28, 2007). The report states that, as of 2004, it does not appear that 

the U.S.-Poland income tax treaty has been extensively exploited by third-country residents. 

The cross-border investment data discussed in section IV.B above might also suggest that foreign 

persons are increasingly investing in the United States through Iceland to obtain treaty benefits. For 

example, the value of U.S. direct investments held by Icelandic persons increased from $2.2 billion in 

2003 to $7.4 billion in 2005; in contrast, the value of Icelandic direct investments held by U.S. persons 

averaged $4 million during the period 2002 through 2005. 
 

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In addition, although the limitation-on-benefits rules in the proposed treaty are similar to 

the rules in other recent and proposed U.S. income tax treaties and protocols and in the U.S. 

Model treaty, they are not identical, and the Committee may wish to inquire about certain 

differences. In particular, the Committee may wish to examine the rules for derivative benefits 

and certain triangular arrangements. 

Finally, the Committee may wish to inquire about the unusual entry-into-force provision 

of the proposed treaty. That provision offers persons seeking treaty benefits an election to apply 

either the present treaty or the proposed treaty for a 12-month period following the date on which 

the proposed treaty would otherwise enter into force. 

Derivative benefits

Like the proposed treaty with Bulgaria and the proposed protocol with Canada, and like 

other recent treaties, the proposed treaty includes derivative benefits rules that are generally 

intended to allow a treaty-country company treaty benefits for an item of income if the 

company’s owners would have been entitled to the same benefits for the income had those 

owners derived the income directly. 

The derivative benefits rules may grant treaty benefits to a treaty-country resident 

company in circumstances in which the company would not qualify for treaty benefits under any 

of the other limitation-on-benefits provisions. The U.S. Model treaty does not include derivative 

benefits rules. The Committee may wish to inquire about the circumstances that justify inclusion 

of these rules in new treaties notwithstanding their absence from the U.S. Model treaty. 

Triangular arrangements

The proposed treaty includes special anti-abuse rules intended to deny treaty benefits in 

certain circumstances in which an Icelandic-resident company earns U.S.-source income 

attributable to a third-country permanent establishment and is subject to little or no tax in the 

third jurisdiction and Iceland. Similar anti-abuse rules are included in other recent treaties and in 

the proposed treaty with Bulgaria. The U.S. Model treaty, however, does not include rules 

addressing triangular arrangements. The Committee may wish to ask the Treasury Department 

why these anti-abuse rules are not included in the U.S. Model treaty. Moreover, in light of their 

absence from the U.S. Model treaty, the Committee may wish to inquire whether the Treasury 

Department will insist on inclusion of such anti-abuse rules whenever a treaty partner’s internal 

tax rules provide an exemption for the income of a third-country permanent establishment of a 

treaty-country resident. 

Entry into force

The proposed treaty includes an unusual rule that allows a person to claim benefits under 

the present treaty even after the proposed treaty has gone into effect. This election is available to 

any person entitled to benefits under the present treaty who would have received greater benefits 

under that treaty than that person would receive under the proposed treaty. This election is 

available for the 12-month period beginning on the date on which the provisions of the proposed 

treaty would otherwise have effect. This rule is not included in the proposed protocol with 

Canada, the U.S. Model treaty, or other recent treaties. 
 

77 

The Committee may wish to ask the Treasury Department about the circumstances that 

justify inclusion of this election in the proposed treaty when doing so allows a person to 

unilaterally determine whether that person may continue to claim benefits under a treaty that the 

United States and Iceland have otherwise replaced. On the one hand, this election may give 

persons who would not otherwise qualify for treaty benefits under the proposed treaty additional 

time to restructure their investments so as to qualify for treaty benefits under the proposed treaty. 

On the other hand, this election may allow persons who cannot, and will not, satisfy the 

limitation-on-benefits rules of the proposed treaty to continue to claim treaty benefits for an 

entire year after the proposed treaty has gone into effect.