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[Senate Executive Report 110-17]
[From the U.S. Government Publishing Office]

110th Congress                                              Exec. Rept.
                                 SENATE
 2d Session                                                      110-17

======================================================================

 
                      TAX CONVENTION WITH ICELAND

                                _______
                                

               September 11, 2008.--Ordered to be printed

                                _______
                                

           Mr. Dodd, from the Committee on Foreign Relations,
                        submitted the following

                                 REPORT

                   [To accompany Treaty Doc. 110-17]

    The Committee on Foreign Relations, to which was referred 
the Convention between the Government of the United States of 
America and the Government of Iceland for the Avoidance of 
Double Taxation and the Prevention of Fiscal Evasion with 
Respect to Taxes on Income, and accompanying Protocol, signed 
at Washington on October 23, 2007 (the ``Treaty'') (Treaty Doc. 
110-17), having considered the same, reports favorably thereon 
with one declaration, as indicated in the resolution of advice 
and consent, and recommends that the Senate give its advice and 
consent to ratification thereof, as set forth in this report 
and the accompanying resolution of advice and consent.

                                CONTENTS

                                                                   Page

  I. Purpose..........................................................1
 II. Background.......................................................2
III. Major Provisions.................................................2
 IV. Entry Into Force.................................................5
  V. Implementing Legislation.........................................6
 VI. Committee Action.................................................6
VII. Committee Recommendation and Comments............................6
VIII.Resolution of Advice and Consent to Ratification.................7

 IX. Annex.--Technical Explanation....................................7

                               I. Purpose

    The Treaty is intended to promote and facilitate trade and 
investment between the United States and Iceland, principally 
through the elimination or reduction in withholding taxes on 
certain cross-border payments of dividends, interest, and 
royalties. In addition, the Treaty contains an anti-treaty-
shopping provision intended to limit abuse of the Treaty by 
third-country residents, which has been a problem associated 
with the current tax treaty with Iceland.

                             II. Background

    The Treaty replaces an existing income tax treaty with 
Iceland, which was concluded in 1975. The main impetus for 
negotiating a new treaty with Iceland was to obtain an anti-
treaty-shopping provision that would limit abuse of the 
existing treaty with Iceland by third-country residents, 
otherwise known as a ``Limitation on Benefits'' or ``LOB'' 
provision. As noted in the President's Letter of Transmittal 
for the Treaty, there has been ``substantial abuse of the 
existing Treaty's provisions by third country investors.'' In 
response to questions from the committee the Treasury 
Department described the evidence on which they based this 
assertion as follows:

          A Treasury Department report to Congress, ``Earning 
        Stripping, Transfer Pricing and U.S. Income Tax Treaties,'' 
        released in November 2007 (2007 Treasury Report), describes 
        abuses of the U.S. tax treaty network by third-country 
        investors, particularly through inappropriate reductions in 
        withholding tax. The 2007 Treasury Report presented data, 
        gathered from U.S. tax returns, on deductible payments such as 
        interest made by U.S. companies to related foreign companies 
        located in treaty jurisdictions. The data suggested that tax 
        treaties that have no LOB provision and a zero rate of 
        withholding tax on deductible payments, such as our treaties 
        with Iceland and Hungary, had begun to be abused by third-
        country investors. In particular, the 2007 Treasury Report 
        notes that while in 1996 almost no U.S.-source interest was 
        paid by foreign-controlled U.S. companies to related parties in 
        Iceland and Hungary, payments of such interest had increased by 
        2004 to over $2 billion. In addition, publicly available 
        information indicates that many of those related parties were 
        ultimately owned by corporations from third countries. This 
        evidence strongly suggests the existence of treaty abuse by 
        third-country residents.

    Modern tax treaties negotiated by the Department of 
Treasury generally contain a Limitation on Benefits provision; 
however, the existing treaty with Iceland contains no such 
provision and thus is easily abused by third-country investors. 
The new Treaty contains a comprehensive Limitation on Benefits 
provision, which is described in greater detail below. 
Presumably, if the Treaty is ratified, as a result of the new 
Limitation on Benefits provision, the amount of tax revenue 
that the United States is currently losing through the abuse of 
the existing treaty will be reduced.

                         III. Major Provisions

    Although the need for a Limitation on Benefits provision 
was the main reason for negotiating a new tax treaty with 
Iceland, a number of other changes were made in the new Treaty. 
A detailed article-by-article analysis of the Treaty may be 
found in the Technical Explanation published by the Department 
of the Treasury on July 10, 2008, which is reprinted in the 
Annex. In addition, the staff of the Joint Committee on 
Taxation prepared an analysis of the Treaty, Document JCX-58-08 
(July 8, 2008), which was of great assistance to the committee 
in reviewing the Treaty. What follows is a discussion of 
certain key provisions.

1. Dividends, Interest, and Royalties

    Like the existing treaty, the new Treaty provides for 
reduced source-country taxation of cross-border dividends and 
would eliminate withholding taxes on all cross-border interest 
payments with minor exceptions. See Articles 10 and 11. Yet, 
while the existing treaty eliminates withholding taxes on all 
cross-border payments of royalties, the new Treaty would allow 
a withholding tax of up to five percent on certain royalties 
with respect to trademarks and certain trademark-related 
industrial, commercial, or scientific experience, motion 
picture films, or works for use in connection with television. 
See Article 12(2).

2. Permanent Establishment and Services

    In general, U.S. bilateral tax treaties attempt to ensure 
that a person or entity is not subject to undue and overly 
burdensome taxation in instances in which the taxpayer has 
minimal contacts with the taxing jurisdiction. This is 
accomplished in the Treaty through 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. 
See Article 7(1). A permanent establishment is generally 
defined as ``a fixed place of business through which the 
business of an enterprise is wholly or partly carried on.'' See 
Article 5(1). Examples include a place of management, offices, 
branches, and factories. See Article 5(2). The Treaty contains 
certain exemptions under which residents of one country 
performing services in the other country will not be required 
to pay tax in the other country unless their contacts with the 
other country exceed specified minimums. See Articles 14 and 
16. These provisions are in line with the 2006 U.S. Model Tax 
Treaty.

3. Limiting Treaty Abuse

    As noted above in Section II, the main reason for updating 
the U.S. bilateral tax treaty with Iceland was to obtain a 
Limitation on Benefits provision, which is designed to avoid 
treaty-shopping by limiting use of the treaty's benefits to 
persons who are intended to receive the advantage of those 
benefits. The new Treaty's LOB provision is in line with the 
2006 U.S. Model Tax Treaty. The provision generally limits 
treaty benefits to treaty country residents such that only 
those residents with a sufficient nexus to the United States or 
Iceland will receive benefits. For example, the LOB provision 
provides that a treaty country company whose shares are 
regularly traded on a recognized stock exchange may qualify for 
treaty benefits if the company satisfies one of two tests: 
either the company must be primarily traded on a recognized 
stock exchange in its country of residence or the company's 
primary place of management and control must be in its country 
of residence. See Article 21(2). This requirement ensures that 
there is an adequate connection to the company's claimed 
country of residence.
    The Treaty also includes special anti-abuse rules intended 
to deny 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, including the Convention with Bulgaria. The 2006 U.S. 
Model Tax Treaty, however, does not include rules addressing 
so-called ``triangular arrangements.'' The Department of 
Treasury indicated that the ``Department's current policy is to 
incorporate the so-called `triangular rule' into tax treaties 
in which the treaty partner exempts from tax certain foreign 
source income such that a tax treaty may be used 
inappropriately in conjunction with certain branch structures 
to exempt fully from tax certain U.S.-source payments.'' The 
Department of Treasury additionally noted that it is 
considering whether to include such a rule in the next update 
of the 2006 U.S. Model Tax Treaty.
    The Treaty includes a transition period during which 
taxpayers impacted by the new LOB provisions will have an 
opportunity to restructure their transactions. The Treaty 
allows a person to claim benefits under the existing treaty 
even after the new Treaty has entered into force, by electing 
to have the existing treaty apply to them for up to one year. 
This ``election'' is available to any person ``entitled to 
greater benefits'' under the existing treaty than that person 
is entitled to under the new Treaty. See Article 27(3). The 
Department of Treasury has explained that this transition 
period was needed in order to reach agreement in 2007 with 
Iceland on the inclusion of the Limitation on Benefits 
provision.

4. Fiscally Transparent Entities

    The 2006 U.S. Model Tax Treaty allows recipients of 
``income, gains, or profits'' through an entity that is 
fiscally transparent under the tax laws of the recipient's 
residence to enjoy the same treaty benefits on that income as 
they would have if the ``income, gains, or profits'' had been 
received by them directly. Fiscally-transparent entities (a 
subset of which are called ``disregarded entities'') are 
entities that act as a conduit, apportioning all income 
received to those holding an interest in the entity.
    The provision in the Iceland Treaty for fiscally 
transparent entities closely parallels the provision in the 
2006 U.S. Model Tax Treaty. But, rather than referring to ``an 
entity that is fiscally transparent,'' the Iceland Treaty 
specifies that the entity be ``a partnership, trust, or 
estate.'' See Article 1(6). Treasury's Technical Explanation 
makes clear that this is intended to include U.S. limited 
liability companies (``LLCs'') that are treated as partnerships 
or as disregarded entities for U.S. tax purposes, including 
LLCs with only one member. In response to Committee questions, 
the Department of Treasury explained why the phrase ``fiscally 
transparent'' was not used, even though the intended meaning of 
the provision appears to be the same, as follows:

          Paragraph 6 of Article 1 of the proposed treaty with Iceland 
        does not use the U.S. Model's phrase ``fiscally transparent'' 
        because that term does not have meaning under the domestic law 
        of Iceland. During the course of the negotiations, the Treasury 
        Department obtained agreement in principle with Iceland over 
        the intent and application of paragraph 6 of Article 1. 
        Accordingly, the Treasury Department believes that the rule 
        will be interpreted and applied by Iceland consistent with the 
        language in the U.S. Model Tax Treaty.

5. Students, Business Trainees, and Researchers

    The Treaty 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. See Articles 16 and 19.

6. Exchange of Information

    The Treaty provides for the exchange of information between 
the tax authorities of each country that is relevant to 
carrying out the provisions of the agreement or the domestic 
tax laws of either country. See Article 25.

7. Pensions, Alimony, and Child Support

    The Treaty differs from the 2006 U.S. Model Tax Treaty in 
some key ways with respect to pensions, alimony, and child 
support.
    Like the 2006 U.S. Model Tax Treaty, the Iceland Treaty 
provides that pension distributions owned by a resident of a 
treaty country are only taxable in the recipient's country of 
residence. The 2006 U.S. Model Tax Treaty, however, contains an 
exception to this provision under which a pension beneficiary's 
country of residence must exempt from tax a pension amount or 
other similar remuneration that would be exempt from tax in the 
other contracting country where the pension fund is 
established, as if the beneficiary had been a resident of that 
other country. The Treaty does not contain this exception.
    Another difference from the 2006 U.S. Model Tax Treaty is 
that the Treaty makes no mention of the tax treatment of child 
support amounts that are paid to a resident of either country. 
Under the 2006 U.S. Model Tax Treaty, child support payments 
paid to a resident of a contracting country are exempt from tax 
in either country. Because the Treaty makes no mention of the 
tax treatment of child support payments, it would be governed 
by Article 20 (Other Income), which assigns the exclusive right 
to tax to the country of residence of the recipient. In 
response to Committee questions, the Treasury Department 
explained that although this was a departure from the Model, 
the result achieved was similar because in most cases child 
support payments are exempt from tax under the domestic law of 
both the United States and Iceland.
    In addition, the Treaty does not contain provisions that 
deal with the tax treatment of cross-border pension 
contributions. These provisions cover, among other things, the 
tax treatment of pension contributions (paid by an individual 
or an individual's employer) when an individual is a 
participant or beneficiary of a pension fund resident in one 
country, but is employed in the other country. In response to 
Committee questions regarding this omission, the Treasury 
Department offered the following explanation:

          The proposed treaty with Iceland does not address the tax 
        treatment of cross-border pension contributions primarily for 
        two reasons. First, the U.S. Model pension funds provision 
        provides for deductibility in one State of contributions to a 
        pension fund of the other State only where the pension fund 
        ``generally corresponds'' to a pension fund in the first state. 
        The provision is, therefore, only appropriate if the two 
        countries have pension systems that are similar. During the 
        course of negotiations, it became clear that Iceland and the 
        United States have very different pension systems. As a result, 
        the provision was not appropriate to include in the proposed 
        treaty. Second, Iceland had limited flexibility in changing by 
        tax treaty its rules for taxing pensions, because those rules 
        are technically under Iceland's pension law, not its tax law.

                          IV. Entry Into Force

    The United States and Iceland shall notify each other in 
writing through diplomatic channels when their respective 
applicable procedures for the entry into force of this Treaty 
have been satisfied. This Treaty shall enter into force on the 
date of receipt of the later of these notifications. The 
various provisions of this Treaty will have effect as described 
in paragraphs 2 and 3 of Article 27.

                      V. Implementing Legislation

    As is the case generally with income tax treaties, the 
Treaty is self-executing and does not require implementing 
legislation for the United States.

                          VI. Committee Action

    The committee held a public hearing on the Treaty on July 
10, 2008. Testimony was received from Mr. Michael Mundaca, 
Deputy Assistant Secretary (International), Office of Tax 
Policy, U.S. Department of the Treasury and Ms. Emily S. 
McMahon, Deputy Chief of Staff to the Joint Committee on 
Taxation. A transcript of this hearing can be found in the 
Annex to Executive Report 110-15.
    On July 29, 2008, the committee considered the Treaty and 
ordered it favorably reported by voice vote, with a quorum 
present and without objection.

               VII. Committee Recommendation and Comments

    The Committee on Foreign Relations believes that the Treaty 
is a significant improvement over the existing treaty with 
Iceland, in particular because of the inclusion of the 
Limitation on Benefits provision that prevents treaty shopping. 
The committee therefore urges the Senate to act promptly to 
give advice and consent to ratification of the Treaty, as set 
forth in this report and the accompanying resolution of advice 
and consent.

                           A. TREATY SHOPPING

    As discussed, one of the most important features of this 
Treaty is the addition of a strong Limitation on Benefits 
provision, which is intended to limit abuse of the Treaty with 
Iceland by third-country residents. With the entry into force 
of the provision, however, it is reasonable to expect that the 
treaty-shopping now occurring through the Iceland Treaty will 
shift to other countries with favorable tax regimes and with 
which the United States has a tax treaty with similar 
advantages, including an exemption from withholding taxes on 
cross-border interest payments but no Limitation on Benefits 
provision to prevent abuse. There are two countries that fit 
this description for which there are tax treaties that are 
currently in force: Hungary and Poland.\1\ Consequently, these 
two countries will likely attract those currently abusing the 
Iceland tax treaty. In addition, as noted by the Treasury 
Department in response to Committee questions on this subject, 
there is already evidence that the treaty with Hungary is being 
substantially abused by third-country investors.
---------------------------------------------------------------------------
    \1\The present treaty between the United States and Iceland is one 
of only eight U.S. income tax treaties that do not include a Limitation 
on Benefits provision of any type. The Iceland Treaty, along with 
treaties with Hungary and Poland are the only three of the eight that 
provide for complete exemption from withholding on interest payments 
from one treaty country to the other treaty country.
---------------------------------------------------------------------------
    The Treasury Department has indicated that ``[u]pdating the 
agreements with Hungary and Poland is a key part of the 
Treasury Department's effort to protect the U.S. tax treaty 
network from abuse.'' Moreover, the Department stated that 
negotiations are ongoing with Hungary and in a preliminary 
stage with Poland. The committee urges the Treasury Department 
in such negotiations not to settle for anything less than a 
robust Limitation on Benefits provision that can be readily 
enforced by the United States, particularly in the case of 
Hungary. The committee is encouraged by the fact that the 
Treasury Department has made this a priority. In the 
committee's view, the Treasury Department should strengthen 
anti-treaty-shopping provisions in tax treaties whenever 
possible, with a particular focus on closing the loophole 
created by those U.S. tax treaties currently in force that do 
not have an anti-treaty-shopping provision.

                             B. RESOLUTION

    The proposed resolution of advice and consent for the 
Treaty includes a declaration.

Declaration

    The committee has included a proposed declaration, which 
states that the Treaty is self-executing, as is the case 
generally with income tax treaties. The committee has in the 
past included such a statement in the committee's report but, 
in light of the recent Supreme Court decision, Medellin v. 
Texas, 128 S. Ct. 1346 (2008), the committee has determined 
that a clear statement in the Resolution is warranted. A 
further discussion of the committee's views on this matter can 
be found in Section VIII of Executive Report 110-12.

         VIII. Resolution of Advice and Consent to Ratification

    Resolved (two-thirds of the Senators present concurring 
therein),

SECTION 1. SENATE ADVICE AND CONSENT SUBJECT TO A DECLARATION

    The Senate advises and consents to the ratification of the 
Convention between the Government of the United States of 
America and the Government of Iceland for the Avoidance of 
Double Taxation and the Prevention of Fiscal Evasion with 
Respect to Taxes on Income, and accompanying Protocol, signed 
at Washington on October 23, 2007 (Treaty Doc. 110-17), subject 
to the declaration of section 2.

SECTION 2. DECLARATION

    The advice and consent of the Senate under section 1 is 
subject to the following declaration:

          This Convention is self-executing.

                   IX. Annex.--Technical Explanation

  DEPARTMENT OF THE TREASURY TECHNICAL EXPLANATION OF THE CONVENTION 
    BETWEEN THE GOVERNMENT OF THE UNITED STATES OF AMERICA AND THE 
  GOVERNMENT OF ICELAND FOR THE AVOIDANCE OF DOUBLE TAXATION AND THE 
     PREVENTION OF FISCAL EVASION WITH RESPECT TO TAXES ON INCOME.

    This is a technical explanation of the Convention between 
the Government of the United States and the Government of 
Iceland For the Avoidance Of Double Taxation and the Prevention 
of Fiscal Evasion with Respect to Taxes on Income, signed on 
October 23, 2007 (the ``Convention'').
    Negotiations took into account the U.S. Treasury 
Department's current tax treaty policy, and the Treasury 
Department's Model Income Tax Convention. Negotiations also 
took into account the Model Tax Convention on Income and on 
Capital, published by the Organisation for Economic Cooperation 
and Development (the ``OECD Model''), and recent tax treaties 
concluded by both countries.
    The Technical Explanation is an official guide to the 
Convention and an accompanying Protocol. It reflects the 
policies behind particular Convention and Protocol provisions, 
as well as understandings reached during the negotiations with 
respect to the application and interpretation of the Convention 
and Protocol. References in the Technical Explanation to ``he'' 
or ``his'' should be read to mean ``he or she'' or ``his and 
her.''

                       ARTICLE 1 (GENERAL SCOPE)

Paragraph 1

    Paragraph 1 of Article 1 provides that the Convention 
applies only to residents of the United States or Iceland 
except where the terms of the Convention provide otherwise. 
Under Article 4 (Resident) a person is generally treated as a 
resident of a Contracting State if that person is, under the 
laws of that State, liable to tax therein by reason of his 
domicile, citizenship, residence, or other similar criteria. 
However, if a person is considered a resident of both 
Contracting States, Article 4 provides rules for determining a 
State of residence (or no State of residence). This 
determination governs for all purposes of the Convention.
    Certain provisions are applicable to persons who may not be 
residents of either Contracting State. For example, paragraph 1 
of Article 23 (Non-Discrimination) applies to nationals of the 
Contracting States. Under Article 25 (Exchange of Information 
and Administrative Assistance), information may be exchanged 
with respect to residents of third states.

Paragraph 2

    Paragraph 2 states the generally accepted relationship both 
between the Convention and domestic law and between the 
Convention and other agreements between the Contracting States. 
That is, no provision in the Convention may restrict any 
exclusion, exemption, deduction, credit or other benefit 
accorded by the tax laws of the Contracting States, or by any 
other agreement between the Contracting States. The 
relationship between the non-discrimination provisions of the 
Convention and other agreements is addressed not in paragraph 2 
but in paragraph 3.
    Under paragraph 2, for example, if a deduction would be 
allowed under the U.S. Internal Revenue Code (the ``Code'') in 
computing the U.S. taxable income of a resident of Iceland, the 
deduction also is allowed to that person in computing taxable 
income under the Convention. Paragraph 2 also means that the 
Convention may not increase the tax burden on a resident of a 
Contracting States beyond the burden determined under domestic 
law. Thus, a right to tax given by the Convention cannot be 
exercised unless that right also exists under internal law.
    It follows that, under the principle of paragraph 2, a 
taxpayer's U.S. tax liability need not be determined under the 
Convention if the Code would produce a more favorable result. A 
taxpayer may not, however, choose among the provisions of the 
Code and the Convention in an inconsistent manner in order to 
minimize tax. Thus, a taxpayer may use the Convention to reduce 
its taxable income, but may not use both treaty and Code rules 
where doing so would thwart the intent of either set of rules. 
For example, assume that 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 under the Code but 
that do not meet the permanent establishment threshold tests of 
the Convention. One is profitable and the other incurs a loss. 
Under the Convention, the income of the permanent establishment 
is taxable in the United States, and both the profit 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 
profits of the two profitable ventures. The taxpayer may not 
invoke the Convention to exclude the profits of the profitable 
trade or business and invoke the Code to claim the loss of the 
loss trade or business against the profit of the permanent 
establishment. (See Rev. Rul. 84-17, 1984-1 C.B. 308.) If, 
however, the taxpayer invokes the Code for the taxation of all 
three ventures, he would not be precluded from invoking the 
Convention 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.
    Similarly, nothing in the Convention can be used to deny 
any benefit granted by any other agreement between the United 
States and Iceland. For example, if certain benefits are 
provided for military personnel or military contractors under a 
Status of Forces Agreement between the United States and 
Iceland, those benefits or protections will be available to 
residents of the Contracting States regardless of any 
provisions to the contrary (or silence) in the Convention.

Paragraph 3

    Paragraph 3 specifically relates to non-discrimination 
obligations of the Contracting States under other agreements. 
The provisions of paragraph 3 are an exception to the rule 
provided in paragraph 2 of this Article under which the 
Convention shall not restrict in any manner any benefit now or 
hereafter accorded by any other agreement between the 
Contracting States.
    Subparagraph 3(a) provides that, notwithstanding any other 
agreement to which the Contracting States may be parties, a 
dispute concerning whether a measure is within the scope of 
this Convention shall be considered only by the competent 
authorities of the Contracting States, and the procedures under 
this Convention exclusively shall apply to that dispute. Thus, 
procedures for dealing with disputes that may be incorporated 
into trade, investment, or other agreements between the 
Contracting States shall not apply for the purposes of 
determining the scope of the Convention.
    Subparagraph 3(b) provides that, unless the competent 
authorities determine that a taxation measure is not within the 
scope of this Convention, the non-discrimination obligations of 
this Convention exclusively shall apply with respect to that 
measure, except for such national treatment or most-favored-
nation (``MFN'') obligations as may apply to trade in goods 
under the General Agreement on Tariffs and Trade (``GATT''). No 
national treatment or MFN obligation under any other agreement 
shall apply with respect to that measure. Thus, unless the 
competent authorities agree otherwise, any national treatment 
and MFN obligations undertaken by the Contracting States under 
agreements other than the Convention shall not apply to a 
taxation measure, with the exception of GATT as applicable to 
trade in goods.

Paragraph 4

    Paragraph 4 contains the traditional saving clause found in 
all U.S. treaties. The Contracting States reserve their rights, 
except as provided in paragraph 5, to tax their residents and 
citizens as provided in their internal laws, notwithstanding 
any provisions of the Convention to the contrary. For example, 
if a resident of Iceland performs professional services in the 
United States and the income from the services is not 
attributable to a permanent establishment in the United States, 
Article 7 (Business Profits) would by its terms prevent the 
United States from taxing the income. If, however, the resident 
of Iceland is also a citizen of the United States, the saving 
clause permits the United States to include the remuneration in 
the worldwide income of the citizen and subject it to tax under 
the normal Code rules (i.e., without regard to Code section 8 
94(a)). However, subparagraph 5(a) of Article 1 preserves the 
benefits of special foreign tax credit rules applicable to the 
U.S. taxation of certain U.S. income of its citizens resident 
in Iceland. See  paragraph 4 of Article 22 (Relief from Double 
Taxation).
    For purposes of the saving clause, ``residence'' is 
determined under Article 4. Thus, an individual who is a 
resident of the United States under the Code (but not a U.S. 
citizen) but who is determined to be a resident of Iceland 
under the tie-breaker rules of Article 4 would be subject to 
U.S. tax only to the extent permitted by the Convention. The 
United States would not be permitted to apply its statutory 
rules to that person to the extent the rules are inconsistent 
with the Convention.
    However, the person would be treated as a U.S. resident for 
U.S. tax purposes other than determining the individual's U.S. 
tax liability. For example, in determining under Code section 
957 whether a foreign corporation is a controlled foreign 
corporation, shares in that corporation held by the individual 
would be considered to be held by a U.S. resident. As a result, 
other U.S. citizens or residents might be deemed to be United 
States shareholders of a controlled foreign corporation subject 
to current inclusion of Subpart F income recognized by the 
corporation. See,  Treas. Reg. section 301.7701 (b)-7(a)(3).
    Under paragraph 4, the United States also reserves its 
right to tax former citizens and former long-term residents for 
a period of ten years following the loss of such status. Thus, 
paragraph 4 allows the United States to tax former U.S. 
citizens and former U.S. long-term residents in accordance with 
Section 877 of the Code. Section 877 generally applies to a 
former citizen or long-term resident of the United States who 
relinquishes citizenship or terminates long-term residency 
before June 17, 2008 if either of the following criteria exceed 
established thresholds: (a) the average annual net income tax 
of such individual for the period of 5 taxable years ending 
before the date of the loss of status, or (b) the net worth of 
such individual as of the date of the loss of status.
    The United States defines ``long-term resident'' as an 
individual (other than a U.S. citizen) who is a lawful 
permanent resident of the United States in at least 8 of the 
prior 15 taxable years. An individual is not treated as a 
lawful permanent resident for any taxable year in which the 
individual is treated as a resident of Iceland under this 
Convention, or as a resident of any country other than the 
United States under the provisions of any other tax treaty of 
the United States, and in either case the individual does not 
waive the benefits of the relevant convention.

Paragraph 5

    Paragraph 5 sets forth certain exceptions to the saving 
clause. The referenced provisions are intended to provide 
benefits to citizens and residents even if such benefits do not 
exist under internal law. Paragraph 5 thus preserves these 
benefits for citizens and residents of the Contracting States.
    Subparagraph 5(a) lists certain provisions of the 
Convention that are applicable to all citizens and residents of 
a Contracting State, despite the general saving clause rule of 
paragraph 4:(1) Paragraph 2 of Article 9 (Associated 
Enterprises) grants the right to a correlative adjustment with 
respect to income tax due on profits reallocated under Article 
9.
    (2) Paragraphs 2 and 4 of Article 17 (Pensions, Social 
Security, and Annuities) provide exemptions from source or 
residence State taxation for certain pension distributions and 
social security payments.
    (3) Article 22 (Relief from Double Taxation) confirms to 
citizens and residents of one Contracting State the benefit of 
a credit for income taxes paid to the other or an exemption for 
income earned in the other State.
    (4) Article 23 (Non-Discrimination) protects residents and 
nationals of one Contracting State against the adoption of 
certain discriminatory practices in the other Contracting 
State.
    (5) Article 24 (Mutual Agreement Procedure) confers certain 
benefits on citizens and residents of the Contracting States in 
order to reach and implement solutions to disputes between the 
two Contracting States. For example, the competent authorities 
are permitted to use a definition of a term that differs from 
an internal law definition. The statute of limitations may be 
waived for refunds, so that the benefits of an agreement may be 
implemented.
    Subparagraph 5(b) provides a different set of exceptions to 
the saving clause. The benefits referred to are all intended to 
be granted to temporary residents of a Contracting State (for 
example, in the case of the United States, holders of non-
immigrant visas), but not to citizens or to persons who have 
acquired permanent residence in that State. If beneficiaries of 
these provisions travel from one of the Contracting States to 
the other, and remain in the other long enough to become 
residents under its internal law, but do not acquire permanent 
residence status (i.e., in the U.S. context, they do not become 
``green card'' holders) and are not citizens of that State, the 
host State will continue to grant these benefits even if they 
conflict with the statutory rules. The benefits preserved by 
this paragraph are: (1) the host country exemptions for 
government service salaries and pensions under Article 18 
(Government Service), certain income of visiting students and 
trainees under Article 19 (Students and Trainees), and the 
income of diplomatic agents and consular officers under Article 
26 (Members of Diplomatic Missions and Consular Posts).

Paragraph 6

    Paragraph 6 provides that an item of income derived by a 
fiscally transparent entity is considered to be derived by a 
resident of a Contracting State to the extent that the resident 
is treated under the taxation laws of the State where he is 
resident as deriving the item of income. This paragraph applies 
to any resident of a Contracting State who is entitled to 
income derived through an entity that is treated as fiscally 
transparent under the laws of either Contracting State. 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 the 
taxation laws of the United States treat one or more U.S. 
residents (whose status as U.S. residents is determined, for 
this purpose, under U.S. tax laws) as deriving the dividend 
income for U.S. tax purposes. In the case of a partnership, the 
persons who are, under U.S. tax laws, treated as partners of 
the entity would normally be the persons whom the U.S. tax laws 
would treat as deriving the dividend income through the 
partnership. Thus, it also follows that persons whom the United 
States treats as partners but who are not U.S. residents for 
U.S. tax purposes may not claim a benefit under the Convention 
for the dividend paid to the entity. Although these partners 
are treated as deriving the income for U.S. tax purposes, they 
are not residents of the United States for purposes of the 
treaty. If, however, they are treated as residents of a third 
country under the provisions of an income tax convention which 
that country has with Iceland, they may be entitled to claim a 
benefit under that convention. In contrast, if an entity is 
organized under U.S. laws and is classified as a corporation 
for U.S. tax purposes, dividends paid by a corporation resident 
in Iceland to the U.S. entity will be considered derived by a 
resident of the United States since the U.S. corporation is 
treated under U.S. taxation laws as a resident of the United 
States and as deriving the income.
    Because the entity classification rules of the State of 
residence govern, the results in the examples discussed above 
would obtain even if the entity were viewed differently under 
the tax laws of Iceland (e.g., as not fiscally transparent in 
the first example above where the entity is treated as a 
partnership for U.S. tax purposes or as fiscally transparent in 
the second example where the entity is viewed as not fiscally 
transparent for U.S. tax purposes). Moreover, these results 
follow regardless of whether the entity is organized in the 
United States, Iceland, or in a third country. For example, 
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. These results also 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 tax purposes of in Iceland.
    Where income is derived through an entity organized in a 
third state that has owners resident in one of the Contracting 
States, the characterization of the entity in that third state 
is irrelevant for purposes of determining whether the resident 
is entitled to treaty benefits with respect to income derived 
by the entity.
    In general, paragraph 6 relates to entities that are not 
subject to tax at the entity level, as distinct from entities 
that are subject to tax, but with respect to which tax may be 
relieve under an integrated system. Entities falling under this 
description in the United States include partnerships, common 
investment trusts under section 584 and grantor trusts. This 
paragraph also applies to U.S. limited liability companies 
((``LLCs''), including an LLC with only one member), that are 
treated as partnerships or as disregarded entities for U.S. tax 
purposes. The taxation laws of a Contracting State may treat an 
item of income as income of a resident of that State even if 
the resident is not subject to tax on that particular item of 
income. For example, if a Contracting State has a participation 
exemption for certain foreign-source dividends and capital 
gains, such income or gains would be regarded as income or gain 
of a resident of that State who otherwise derived the income or 
gain, despite the fact that the resident could be exempt from 
tax in that State on the income or gain.
    Paragraph 6 is not an exception to the saving clause of 
paragraph 4. Accordingly, paragraph 6 does not prevent a 
Contracting State from taxing an entity that is treated as a 
resident of that State under its own tax law. For example, if a 
U.S. LLC with members who are residents of Iceland elects to be 
taxed as a corporation for U.S. tax purposes, the United States 
will tax that LLC on its worldwide income on a net basis, 
without regard to whether Iceland views the LLC as fiscally 
transparent.

                       ARTICLE 2 (TAXES COVERED)

    This Article specifies the U.S. taxes and the taxes of 
Iceland to which the Convention applies. With two exceptions, 
the taxes specified in Article 2 are the covered taxes for all 
purposes of the Convention. A broader coverage applies for 
purposes of Articles 23 (Non-Discrimination) and 25 (Exchange 
of Information and Administrative Assistance). Article 23 
applies with respect to all taxes, including those imposed by 
state and local governments. Article 25 applies with respect to 
all taxes imposed at the national level.

Paragraph 1

    Paragraph 1 identifies the category of taxes to which the 
Convention applies. Paragraph 1 is based on the U. S. and OECD 
Models and defines the scope of application of the Convention. 
The Convention applies to taxes on income, including gains, 
imposed on behalf of a Contracting State, irrespective of the 
manner in which they are levied. Except with respect to Article 
23 state and local taxes are not covered by the Convention.

Paragraph 2

    Paragraph 2 also is based on the U.S. and OECD Models and 
provides a definition of taxes on income, on capital and on 
capital gains. The Convention covers taxes on total income, on 
total capital, or any part of income and includes tax on gains 
derived from the alienation of property. The Convention does 
not apply, however, to social security charges, or any other 
charges where there is a direct connection between the levy and 
individual benefits. Social security and unemployment taxes 
(Code sections 1401, 3101, 3111 and 3301) are excluded from 
coverage. The Convention also does not apply to property taxes, 
except with respect to Article 23.

Paragraph 3

    Paragraph 3 lists the taxes in force at the time of 
signature of the Convention to which the Convention applies.
    The existing covered taxes of Iceland are identified in 
subparagraph 3(a). These taxes are i) the income taxes to the 
state and ii) the income taxes to the municipalities.
    Subparagraph 3(b) provides that the existing U.S. taxes 
subject to the rules of the Convention are the Federal income 
taxes imposed by the Code, together with the excise taxes 
imposed with respect to private foundations (Code sections 4940 
through 4948).

Paragraph 4

    Under paragraph 4, the Convention will apply to any taxes 
that are identical, or substantially similar, to those 
enumerated in paragraph 3, and which are imposed in addition 
to, or in place of, the existing taxes after October 23, 2007, 
the date of signature of the Convention. The paragraph also 
provides that the competent authorities of the Contracting 
States will notify each other of any significant changes that 
have been made in their laws, whether tax laws or non-tax laws, 
that affect significantly their obligations under the 
Convention. Non-tax laws that may affect a Contracting State's 
obligations under the Convention may include, for example, laws 
affecting bank secrecy.

                    ARTICLE 3 (GENERAL DEFINITIONS)

    Article 3 provides general definitions and rules of 
interpretation applicable throughout the Convention. Certain 
other terms are defined in other articles of the Convention. 
For example, the term ``resident of a Contracting State'' is 
defined in Article 4 (Resident). The term ``permanent 
establishment'' is defined in Article 5 (Permanent 
Establishment). These definitions are used consistently 
throughout the Convention. Other terms, such as ``dividends,'' 
``interest'' and ``royalties'' are defined in specific articles 
for purposes only of those articles.

Paragraph 1

    Paragraph 1 defines a number of basic terms used in the 
Convention. The introduction to paragraph 1 makes clear that 
these definitions apply for all purposes of the Convention, 
unless the context requires otherwise. This latter condition 
allows flexibility in the interpretation of the treaty in order 
to avoid results not intended by the treaty's negotiators.
    The geographical scope of the Convention with respect 
Iceland is set out in subparagraph 1(a). 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 adjacent waters, and their natural resources.
    The geographical scope of the Convention with respect to 
the United States is set out in subparagraph 1(b). It 
encompasses the United States of America, including the states, 
the District of Columbia and the territorial sea of the United 
States. The term does not include Puerto Rico, the Virgin 
Islands, Guam or any other U.S. possession or territory. For 
certain purposes, the term ``United States'' includes the sea 
bed and subsoil of undersea areas adjacent to the territorial 
sea of the United States. This extension applies to the extent 
that the United States exercises sovereignty in accordance with 
international law for the purpose of natural resource 
exploration and exploitation of such areas. This extension of 
the definition applies, however, only if the person, property 
or activity to which the Convention is being applied is 
connected with such natural resource exploration or 
exploitation. Thus, it would not include any activity involving 
the sea floor of an area over which the United States exercised 
sovereignty for natural resource purposes if that activity was 
unrelated to the exploration and exploitation of natural 
resources. This result is consistent with the result that would 
be obtained under Section 638, which treats the continental 
shelf as part of the United States for purposes of natural 
resource exploration and exploitation.
    Subparagraph 1(c) defines the term ``person'' to include an 
individual, a trust, a partnership, a company and any other 
body of persons. The definition is significant for a variety of 
reasons. For example, under Article 4, only a ``person'' can be 
a ``resident'' and therefore eligible for most benefits under 
the treaty. Also, all ``persons'' are eligible to claim relief 
under Article 24 (Mutual Agreement Procedure).
    The term ``company'' is defined in subparagraph 1(d) as a 
body corporate or an entity treated as a body corporate for tax 
purposes in the state where it is organized. The definition 
refers to the law of the state in which an entity is organized 
in order to ensure that an entity that is treated as fiscally 
transparent in its country of residence will not get 
inappropriate benefits, such as the reduced withholding rate 
provided by subparagraph 2(b) of Article 10 (Dividends). It 
also ensures that the Limitation on Benefits provisions of 
Article 21 will be applied at the appropriate level.
    Subparagraph 1(e) defines the term ``enterprise'' as any 
activity or set of activities that constitutes the carrying on 
of a business. The term ``business'' is not defined, but 
subparagraph (k) provides that it includes the performance of 
professional services and other activities of an independent 
character. Both subparagraphs are identical to definitions 
recently added to the OECD Model in connection with the 
deletion of Article 14 (Independent Personal Services) from the 
OECD Model. The inclusion of the two definitions 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).
    The terms ``enterprise of a Contracting State'' and 
``enterprise of the other Contracting State'' are defined in 
subparagraph 1(f) as an enterprise carried on by a resident of 
a Contracting State and an enterprise carried on by a resident 
of the other Contracting State. An enterprise of a Contracting 
State need not be carried on in that State. It may be carried 
on in the other Contracting State or a third state (e.g., a 
U.S. corporation doing all of its business in the other 
Contracting State would still be a U.S. enterprise). Although 
not explicitly stated in the Convention, these terms also 
encompass an enterprise conducted through an entity (such as a 
partnership) that is treated as fiscally transparent in the 
Contracting State where the entity's owner is resident. In 
accordance with Article 4 (Resident), entities that are 
fiscally transparent in the Contracting State in which their 
owners are resident are not considered to be residents of that 
State (although income derived by such entities may be taxed as 
the income of a resident, if taxed in the hands of resident 
partners or other owners). An enterprise conducted by such an 
entity will be treated as carried on by a resident of a 
Contracting State to the extent its partners or other owners 
are residents. This approach is consistent with the Code, which 
under section 875 attributes a trade or business conducted by a 
partnership to its partners and a trade or business conducted 
by an estate or trust to its beneficiaries.
    Subparagraph 1(g) provides that the terms ``a Contracting 
State'' and ``the other Contracting State'' shall mean Iceland 
or the United States, as the context requires.
    Subparagraph 1(h) defines the term ``international 
traffic.'' The term means any transport by a ship or aircraft 
except when such transport is solely between places within a 
Contracting State. This definition is applicable principally in 
the context of Article 8 (Shipping and Air Transport). The 
definition combines with paragraphs 2 and 3 of Article 8 to 
exempt from tax by the source State income from the rental of 
ships or aircraft that is earned both by lessors that are 
operators of ships and aircraft and by those lessors that are 
not (e.g., a bank or a container leasing company).
    The exclusion from international traffic of transport 
solely between places within a Contracting State means, for 
example, that carriage of goods or passengers solely between 
New York and Chicago would not be treated as international 
traffic, whether carried by a U.S. or a foreign carrier. The 
substantive taxing rules of the Convention relating to the 
taxation of income from transport, principally Article 8 
(Shipping and Air Transport), therefore, would not apply to 
income from such carriage. Thus, if the carrier engaged in 
internal U.S. traffic were a resident of Iceland (assuming that 
were possible under U.S. law), the United States would not be 
required to exempt the income from that transport under Article 
8. The income would, however, be treated as business profits 
under Article 7 (Business Profits), and therefore would be 
taxable in the United States only if attributable to a U.S. 
permanent establishment of the foreign carrier, and then only 
on a net basis. The gross basis U.S. tax imposed by section 887 
would never apply under the circumstances described. If, 
however, goods or passengers are carried by a carrier resident 
in Iceland from a non-U.S. port to, for example, New York, and 
some of the goods or passengers continue on to Chicago, the 
entire transport would be international traffic. This would be 
true if the international carrier transferred the goods at the 
U.S. port of entry from a ship to a land vehicle, from a ship 
to a lighter, or even if the overland portion of the trip in 
the United States was handled by an independent carrier under 
contract with the original internation*al carrier, so long as 
both parts of the trip were reflected in original bills of 
lading. For this reason, the Convention, following the U.S. 
Model, refers in the definition of ``international traffic,'' 
to ``such transport'' being solely between places in the other 
Contracting State, while the OECD Model refers to the ship or 
aircraft being operated solely between such places. The 
formulation in the Convention is intended to make clear that, 
as in the above example, even if the goods are carried on a 
different aircraft for the internal portion of the 
international voyage than is used for the overseas portion of 
the trip, the definition applies to that internal portion as 
well as the external portion.
    Finally, a ``cruise to nowhere,'' i.e., a cruise beginning 
and ending in a port in the same Contracting State with no 
stops in a foreign port, would not constitute international 
traffic.
    Subparagraph 1(i) 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. 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. With 
respect to interpretative issues, the Deputy Commissioner 
(International) LMSB acts with the concurrence of the Associate 
Chief Counsel (International) of the Internal Revenue Service.
    The term ``national,'' as it relates to the United States 
and to Iceland, is defined in subparagraph 1(j). This term is 
relevant for purposes of Articles 18 (Government Service) and 
23 (Non-Discrimination). A national of one of the Contracting 
States is (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 law in force 
in the State where it is established.
    Subparagraph 1(l) defines the term ``pension scheme'' to 
include any plan, scheme, fund, trust or other arrangement 
established in a Contracting State that is generally exempt 
from income taxation in that State and 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. Subparagraph 1(b) of the Protocol provides that 
in the case of the United States, the term ``pension scheme'' 
includes the following: a trust providing pension or retirement 
benefits under a Code section 401(a) qualified pension plan, 
profit sharing or stock bonus plan, a Code section 403(a) 
qualified annuity plan, a Code section 403(b) plan, a trust 
that is an individual retirement account under Code section 
408, a Roth individual retirement account under Code section 
408A, or a simple retirement account under Code section 408(p), 
a trust providing pension or retirement benefits under a 
simplified employee pension plan under Code section 408(k), a 
trust described in section 457(g) providing pension or 
retirement benefits under a Code section 457(b) plan, and the 
Thrift Savings Fund (section 7701(j)). Section 401(k) plans and 
group trusts described in Revenue Ruling 8 1-100 and meeting 
the conditions of Revenue Ruling 2004-67 qualify as pension 
funds to the extent they are Code section 401(a) plans or other 
pension schemes. In the case of Iceland, subparagraph 1(a) of 
the Protocol provides that the term ``pension scheme'' includes 
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 October 23, 2007, the date 
of signature of the Convention.

Paragraph 2

    Terms that are not defined in the Convention are dealt with 
in paragraph 2.
    Paragraph 2 provides that in the application of the 
Convention, any term used but not defined in the Convention 
will have the meaning that it has under the law of the 
Contracting State whose tax is being applied, 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 Contracting State, the definition in the 
tax law will take precedence over the definition in the non-tax 
laws. Finally, there also may be cases where the tax laws of a 
State contain multiple definitions of the same term. In such a 
case, the definition used for purposes of the particular 
provision at issue, if any, should be used.
    If the meaning of a term cannot be readily determined under 
the law of a Contracting State, or if there is a conflict in 
meaning under the laws of the two States that creates 
difficulties in the application of the Convention, the 
competent authorities, as indicated in subparagraph 3(f) of 
Article 24, may establish a common meaning in order to prevent 
double taxation or to further any other purpose of the 
Convention. This common meaning need not conform to the meaning 
of the term under the laws of either Contracting State.
    The reference in paragraph 2 to the internal law of a 
Contracting State means the law in effect at the time the 
treaty is being applied, not the law as in effect at the time 
the treaty was signed. The use of ``ambulatory'' definitions, 
however, may lead to results that are at variance with the 
intentions of the negotiators and of the Contracting States 
when the treaty was negotiated and ratified. The reference in 
both paragraphs 1 and 2 to the ``context otherwise 
requir[ing]'' a definition different from the treaty 
definition, in paragraph 1, or from the internal law definition 
of the Contracting State whose tax is being imposed, under 
paragraph 2, refers to a circumstance where the result intended 
by the Contracting States is different from the result that 
would obtain under either the paragraph 1 definition or the 
statutory definition. Thus, flexibility in defining terms is 
necessary and permitted.

                          ARTICLE 4 (RESIDENT)

    This Article sets forth rules for determining whether a 
person is a resident of a Contracting State for purposes of the 
Convention. As a general matter only residents of the 
Contracting States may claim the benefits of the Convention. 
The treaty definition of residence is to be used only for 
purposes of the Convention. The fact that a person is 
determined to be a resident of a Contracting State under 
Article 4 does not necessarily entitle that person to the 
benefits of the Convention. In addition to being a resident, a 
person also must qualify for benefits under Article 21 
(Limitation On Benefits) in order to receive benefits conferred 
on residents of a Contracting State.
    The determination of residence for treaty purposes looks 
first to a person's liability to tax as a resident under the 
respective taxation laws of the Contracting States. As a 
general matter, a person who, under those laws, is a resident 
of one Contracting State and not of the other need look no 
further. For purposes of the Convention, that person is a 
resident of the State in which he is resident under internal 
law. If, however, a person is resident in both Contracting 
States under their respective taxation laws, the Article 
proceeds, where possible, to use tie-breaker rules to assign a 
single State of residence to such a person for purposes of the 
Convention.

Paragraph 1

    The term ``resident of a Contracting State'' is defined in 
paragraph 1. In general, this definition incorporates the 
definitions of residence in U.S. law and that of Iceland by 
referring to a resident as a person who, under the laws of a 
Contracting State, is subject to tax there by reason of his 
domicile, residence, citizenship, place of management, place of 
incorporation or any other similar criterion. Thus, residents 
of the United States include aliens who are considered U.S. 
residents under Code section 7701(b). Paragraph 1 also 
specifically includes the two Contracting States, and political 
subdivisions and local authorities of the two States, as 
residents for purposes of the Convention.
    Certain entities that are nominally subject to tax but that 
in practice are rarely required to pay tax also would generally 
be treated as residents and therefore accorded treaty benefits. 
For example, a U.S. Regulated Investment Company (RIC) and a 
U.S. Real Estate Investment Trust (REIT) are residents of the 
United States for purposes of the treaty. Although the income 
earned by these entities normally is not subject to U.S. tax in 
the hands of the entity, they are taxable to the extent that 
they do not currently distribute their profits, and therefore 
may be regarded as ``liable to tax.'' They also must satisfy a 
number of requirements under the Code in order to be entitled 
to special tax treatment.
    A person who is liable to tax in a Contracting State only 
in respect of income from sources within that State or capital 
situated therein or of profits attributable to a permanent 
establishment in that State will not be treated as a resident 
of that Contracting State for purposes of the Convention. Thus, 
a consular official of Iceland who is posted in the United 
States, who may be subject to U.S. tax on U.S. source 
investment income but is not taxable in the United States on 
non-U.S. source income (see Code section 7701(b)(5)(B)), would 
not be considered a resident of the United States for purposes 
of the Convention. Similarly, an enterprise of Iceland with a 
permanent establishment in the United States is not, by virtue 
of that permanent establishment, a resident of the United 
States. The enterprise generally is subject to U.S. tax only 
with respect to its income that is attributable to the U.S. 
permanent establishment, not with respect to its worldwide 
income, as it would be if it were a U.S. resident.

Paragraph 2

    Paragraph 2 provides that certain tax-exempt entities such 
as pension schemes and charitable organizations will be 
regarded as residents of a Contracting State regardless of 
whether they are generally liable to income tax in the State 
where they are established. The inclusion of this provision is 
intended to clarify the generally accepted practice of treating 
an entity that would be liable for tax as a resident under the 
internal law of a State but for a specific exemption from tax 
(either complete or partial) as a resident of that State for 
purposes of paragraph 1.
    Subparagraph 2(a) applies to pension schemes, as defined in 
subparagraph 1(l) of Article 3 (General Definitions). 
Subparagraph 2(b) applies to any plan, scheme, fund, trust, 
company or other arrangement established in a Contracting State 
that is generally exempt from taxation in that State because it 
is operated exclusively to administer or provide employee 
benefits. The reference to a general exemption is intended to 
reflect the fact that under U.S. law, certain organizations 
that generally are considered to be tax-exempt entities may be 
subject to certain excise taxes or to income tax on their 
unrelated business income. Subparagraph 2(c) applies to an 
organization that is established exclusively for religious, 
charitable, scientific, artistic, cultural, or educational 
purposes and that is a resident of a Contracting State. Thus, a 
section 501(c) organization organized in the United States 
(such as a U.S. charity) that is generally exempt from tax 
under U.S. law is a resident of the United States for all 
purposes of the Convention.

Paragraph 3

    If, under the laws of the two Contracting States, and, 
thus, under paragraph 1, an individual is deemed to be a 
resident of both Contracting States, a series of tie-breaker 
rules are provided in paragraph 3 to determine a single State 
of residence for that individual. These tests are to be applied 
in the order in which they are stated. The first test is based 
on where the individual has a permanent home. If that test is 
inconclusive because the individual has a permanent home 
available to him in both States, he will be considered to be a 
resident of the Contracting State where his personal and 
economic relations are closest (i.e., the location of his 
``center of vital interests''). If that test is also 
inconclusive, or if he does not have a permanent home available 
to him in either State, he will be treated as a resident of the 
Contracting State where he maintains a habitual abode. If he 
has a habitual abode in both States or in neither of them, he 
will be treated as a resident of the Contracting State of which 
he is a national. If he is a national of both States or of 
neither, the matter will be considered by the competent 
authorities, who will assign a single State of residence.

Paragraph 4

    Paragraph 4 seeks to settle dual residence issues for 
persons other than individuals (e.g., companies, trusts, or 
estates). For example, a dual residence may arise in the case 
of a company that is dually created in both the United States 
and Iceland or that is incorporated in the United States, and 
therefore treated as a resident of the United States, but that 
is also considered a resident of Iceland because it is managed 
and controlled in Iceland. In such a case, if such a person is, 
under the rules of paragraph 1, resident in both Contracting 
States, the competent authorities shall seek to determine a 
single State of residence for that person for purposes of the 
Convention. If the competent authorities do not reach an 
agreement on a single State of residence, that company may not 
claim any benefit accorded to residents of a Contracting State 
by the Convention, except those provided in Article 23 (Non-
Discrimination) and Article 24 (Mutual Agreement Procedure). 
Thus, for example, a State cannot impose discriminatory tax 
measures on a dual resident company.
    Dual resident companies may be treated as a resident of a 
Contracting State for purposes other than that of obtaining 
benefits under the Convention. For example, if a dual resident 
company pays a dividend to a resident of Iceland, the U.S. 
paying agent would withhold on that dividend at the appropriate 
treaty rate because reduced withholding is a benefit enjoyed by 
the resident of Iceland, not by the dual resident company. The 
dual resident company that paid the dividend would, for this 
purpose, be treated as a resident of the United States under 
the Convention. In addition, information relating to dual 
resident companies can be exchanged under the Convention 
because, by its terms, Article 26 (Exchange of Information and 
Administrative Assistance) is not limited to residents of the 
Contracting States.

                  ARTICLE 5 (PERMANENT ESTABLISHMENT)

    This Article defines the term ``permanent establishment,'' 
a term that is significant for several articles of the 
Convention. The existence of a permanent establishment in a 
Contracting State is necessary under Article 7 (Business 
Profits) for the taxation by that State of the business profits 
of a resident of the other Contracting State. Articles 10 
(Dividends), 11 (Interest) and 12 (Royalties) provide for 
reduced rates of tax at source on payments of these items of 
income to a resident of the other State only when the income is 
not attributable to a permanent establishment that the 
recipient has in the source State. The concept is also relevant 
in determining which Contracting State may tax certain gains 
under Article 13 (Capital Gains) and certain ``other income'' 
under Article 20 (Other Income).

Paragraph 1

    The basic definition of the term ``permanent 
establishment'' is contained in paragraph 1. As used in the 
Convention, the term means a fixed place of business through 
which the business of an enterprise is wholly or partly carried 
on. As indicated in the OECD Commentary to Article 5 (see 
paragraphs 4 through 8), a general principle to be observed in 
determining whether a permanent establishment exists is that 
the place of business must be ``fixed'' in the sense that a 
particular building or physical location is used by the 
enterprise for the conduct of its business, and that it must be 
foreseeable that the enterprise's use of this building or other 
physical location will be more than temporary.

Paragraph 2

    Paragraph 2 lists a number of types of fixed places of 
business that constitute a permanent establishment. This list 
is illustrative and non-exclusive. According to paragraph 2, 
the term permanent establishment includes a place of 
management, a branch, an office, a factory, a workshop, and a 
mine, oil or gas well, quarry or other place of extraction of 
natural resources.

Paragraph 3

    This paragraph provides rules to determine whether a 
building site or a construction, assembly or installation 
project, or an installation or drilling rig or ship used for 
the exploration of natural resources constitutes a permanent 
establishment for the contractor, driller, etc. Such a site or 
activity does not create a permanent establishment unless the 
site, project, etc. lasts, or the exploration activity 
continues, for more than twelve months. It is only necessary to 
refer to ``exploration'' and not ``exploitation'' in this 
context because exploitation activities are defined to 
constitute a permanent establishment under subparagraph 2(f). 
Thus, a drilling rig does not constitute a permanent 
establishment if a well is drilled in only six months, but if 
production begins in the following month the well becomes a 
permanent establishment as of that date.
    The twelve-month test applies separately to each site or 
project. The twelve-month period begins when work (including 
preparatory work carried on by the enterprise) physically 
begins in a Contracting State. A series of contracts or 
projects by a contractor that are interdependent both 
commercially and geographically are to be treated as a single 
project for purposes of applying the twelve-month threshold 
test. For example, the construction of a housing development 
would be considered as a single project even if each house were 
constructed for a different purchaser.
    In applying this paragraph, time spent by a sub-contractor 
on a building site is counted as time spent by the general 
contractor at the site for purposes of determining whether the 
general contractor has a permanent establishment. However, for 
the sub-contractor itself to be treated as having a permanent 
establishment, the sub-contractor's activities at the site must 
last for more than 12 months. If a sub-contractor is on a site 
intermittently, then, for purposes of applying the 12-month 
rule, time is measured from the first day the sub-contractor is 
on the site until the last day (i.e., intervening days that the 
sub-contractor is not on the site are counted).
    These interpretations of the Article are based on the 
Commentary to paragraph 3 of Article 5 of the OECD Model, which 
contains language that is substantially the same as that in the 
Convention. These interpretations are consistent with the 
generally accepted international interpretation of the relevant 
language in paragraph 3 of Article 5 of the Convention.
    If the twelve-month threshold is exceeded, the site or 
project constitutes a permanent establishment from the first 
day of activity.

Paragraph 4

    This paragraph contains exceptions to the general rule of 
paragraph 1, listing a number of activities that may be carried 
on through a fixed place of business but which nevertheless do 
not create a permanent establishment. The use of facilities 
solely to store, display or deliver merchandise belonging to an 
enterprise does not constitute a permanent establishment of 
that enterprise. The maintenance of a stock of goods belonging 
to an enterprise solely for the purpose of storage, display or 
delivery, or solely for the purpose of processing by another 
enterprise does not give rise to a permanent establishment of 
the first-mentioned enterprise. The maintenance of a fixed 
place of business solely for the purpose of purchasing goods or 
merchandise, or for collecting information, for the enterprise, 
or for other activities that have a preparatory or auxiliary 
character for the enterprise, such as advertising, or the 
supply of information, do not constitute a permanent 
establishment of the enterprise. Moreover, subparagraph 4(f) 
provides that a combination of the activities described in the 
other subparagraphs of paragraph 4 will not give rise to a 
permanent establishment if the combination results in an 
overall activity that is of a preparatory or auxiliary 
character.

Paragraph 5

    Paragraphs 5 and 6 specify when activities carried on by an 
agent or other person acting on behalf of an enterprise create 
a permanent establishment of that enterprise. Under paragraph 
5, a person is deemed to create a permanent establishment of 
the enterprise if that person has and habitually exercises an 
authority to conclude contracts in the name of the enterprise. 
If, however, for example, his activities are limited to those 
activities specified in paragraph 4 which would not constitute 
a permanent establishment if carried on by the enterprise 
through a fixed place of business, the person does not create a 
permanent establishment of the enterprise.
    The Convention adopts the OECD Model language ``in the name 
of the enterprise ``rather than the U.S. Model language 
``binding on the enterprise.'' This difference in language is 
not intended to be a substantive difference. As indicated in 
paragraph 32 to the OECD Commentaries on Article 5, paragraph 5 
is intended to encompass persons who have ``sufficient 
authority to bind the enterprise's participation in the 
business activity in the State concerned.''
    The contracts referred to in paragraph 5 are those relating 
to the essential business operations of the enterprise, rather 
than ancillary activities. For example, if the person has no 
authority to conclude contracts in the name of the enterprise 
with its customers for, say, the sale of the goods produced by 
the enterprise, but it can enter into service contracts in the 
name of the enterprise for the enterprise's business equipment, 
this contracting authority would not fall within the scope of 
the paragraph, even if exercised regularly.

Paragraph 6

    Under paragraph 6, an enterprise is not deemed to have a 
permanent establishment in a Contracting State merely because 
it carries on business in that State through an independent 
agent, including a broker or general commission agent, if the 
agent is acting in the ordinary course of his business as an 
independent agent. Thus, there are two conditions that must be 
satisfied: the agent must be both legally and economically 
independent of the enterprise, and the agent must be acting in 
the ordinary course of its business in carrying out activities 
on behalf of the enterprise.
    Whether the agent and the enterprise are independent is a 
factual determination. Among the questions to be considered are 
the extent to which the agent operates on the basis of 
instructions from the enterprise. An agent that is subject to 
detailed instructions regarding the conduct of its operations 
or comprehensive control by the enterprise is not legally 
independent.
    In determining whether the agent is economically 
independent, a relevant factor is the extent to which the agent 
bears business risk. Business risk refers primarily to risk of 
loss. An independent agent typically bears risk of loss from 
its own activities. In the absence of other factors that would 
establish dependence, an agent that shares business risk with 
the enterprise, or has its own business risk, is economically 
independent because its business activities are not integrated 
with those of the principal. Conversely, an agent that bears 
little or no risk from the activities it performs is not 
economically independent and therefore is not described in 
paragraph 6.
    Another relevant factor in determining whether an agent is 
economically independent is whether the agent acts exclusively 
or nearly exclusively for the principal. Such a relationship 
may indicate that the principal has economic control over the 
agent. A number of principals acting in concert also may have 
economic control over an agent. The limited scope of the 
agent's activities and the agent's dependence on a single 
source of income may indicate that the agent lacks economic 
independence. It should be borne in mind, however, that 
exclusivity is not in itself a conclusive test; an agent may be 
economically independent notwithstanding an exclusive 
relationship with the principal if it has the capacity to 
diversify and acquire other clients without substantial 
modifications to its current business and without substantial 
harm to its business profits. Thus, exclusivity should be 
viewed merely as a pointer to further investigation of the 
relationship between the principal and the agent. Each case 
must be addressed on the basis of its own facts and 
circumstances.

Paragraph 7

    This paragraph clarifies that a company that is a resident 
of a Contracting State is not deemed to have a permanent 
establishment in the other Contracting State merely because it 
controls, or is controlled by, a company that is a resident of 
that other Contracting State, or that carries on business in 
that other Contracting State. The determination whether a 
permanent establishment exists is made solely on the basis of 
the factors described in paragraphs 1 through 6 of the Article. 
Whether a company is a permanent establishment of a related 
company, therefore, is based solely on those factors and not on 
the ownership or control relationship between the companies.

       ARTICLE 6 (INCOME FROM IMMOVABLE PROPERTY (REAL PROPERTY))

    This Article deals with the taxation of income from 
immovable property (real property) situated in a Contracting 
State (the ``situs State''). The Article does not grant an 
exclusive taxing right to the situs State; the situs State is 
merely given the primary right to tax. The Article does not 
impose any limitation in terms of rate or form of tax imposed 
by the situs State.

Paragraph 1

    The first paragraph of Article 6 states the general rule 
that income of a resident of a Contracting State derived from 
real property situated in the other Contracting State may be 
taxed in the Contracting State in which the property is 
situated. The paragraph specifies that income from real 
property includes income from agriculture and forestry.

Paragraph 2

    The term ``real property'' is defined in paragraph 2 by 
reference to the internal law definition in the situs State. In 
the case of the United States, the term has the meaning given 
to it by Reg. Sec. 1.897-1(b). In addition to the statutory 
definitions in the two Contracting States, the paragraph 
specifies certain additional classes of property that, 
regardless of internal law definitions, are within the scope of 
the term for purposes of the Convention. This expanded 
definition conforms to that in the OECD Model. The definition 
of ``real property'' for purposes of Article 6 is more limited 
than the expansive definition of ``real property'' in paragraph 
1 of Article 13 (Capital Gains). The Article 13 term includes 
not only real property as defined in Article 6 but certain 
other interests in real property.

Paragraph 3

    Paragraph 3 makes clear that all forms of income derived 
from the exploitation of real property are taxable in the 
Contracting State in which the property is situated. This 
includes income from any use of real property, including, but 
not limited to, income from direct use by the owner (in which 
case income may be imputed to the owner for tax purposes) and 
rental income from the letting of real property. In the case of 
a net lease of real property, if any elections to be taxed on a 
net basis as may be provided under the laws of the situs State 
have not been made, the gross rental payment (before deductible 
expenses incurred by the lessee) is treated as income from the 
property.
    Other income closely associated with real property is 
covered by other Articles of the Convention, however, and not 
Article 6. For example, income from the disposition of an 
interest in real property is not considered ``derived'' from 
real property; taxation of that income is addressed in Article 
13. Interest paid on a mortgage on real property would be 
covered by Article 11 (Interest). Distributions by a U.S. Real 
Estate Investment Trust or certain regulated investment 
companies would fall under Article 13 in the case of 
distributions of U.S. real property gain or Article 10 
(Dividends) in the case of distributions treated as dividends. 
Finally, distributions from a United States Real Property 
Holding Corporation are not considered to be income from the 
exploitation of real property; such payments would fall under 
Article 10 or 13.

Paragraph 4

    This paragraph specifies that the basic rule of paragraph 1 
(as elaborated in paragraph 3) applies to income from real 
property of an enterprise. This clarifies that the situs 
country may tax the real property income (including rental 
income) of a resident of the other Contracting State in the 
absence of attribution to a permanent establishment in the 
situs State. This provision represents an exception to the 
general rule under Articles 7 (Business Profits) that income 
must be attributable to a permanent establishment in order to 
be taxable in the situs State.

                      ARTICLE 7 (BUSINESS PROFITS)

    This Article provides rules for the taxation by a 
Contracting State of the business profits of an enterprise of 
the other Contracting State.

Paragraph 1

    Paragraph 1 states the general rule that business profits 
of an enterprise of one Contracting State may not be taxed by 
the other Contracting State unless the enterprise carries on 
business in that other Contracting State through a permanent 
establishment (as defined in Article 5 (Permanent 
Establishment)) situated there. When that condition is met, the 
State in which the permanent establishment is situated may tax 
the enterprise on the income that is attributable to the 
permanent establishment.
    Although the Convention does not include a definition of 
``business profits,'' the term is intended to cover income 
derived from any trade or business. In accordance with this 
broad definition, the term ``business profits'' 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 such 
instruments is, unless specifically covered in another article, 
dealt with under Article 20 (Other Income).
    The term ``business profits'' also includes income derived 
by an enterprise from the rental of tangible personal property 
(unless such tangible personal property consists of aircraft, 
ships or containers, income from which is addressed by Article 
8 (Shipping and Air Transport)). The inclusion of income 
derived by an enterprise from the rental of tangible personal 
property in business profits means that such income earned by a 
resident of a Contracting State can be taxed by the other 
Contracting State only if the income is attributable to a 
permanent establishment maintained by the resident in that 
other State, and, if the income is taxable, it can be taxed 
only on a net basis. Income from the rental of tangible 
personal property that is not derived in connection with a 
trade or business is dealt with in Article 20.
    In addition, as a result of the definitions of 
``enterprise'' and ``business'' in Article 3 (General 
Definitions), the term includes income derived from the 
furnishing of personal services. Thus, a consulting firm 
resident in one State whose employees or partners perform 
services in the other State through a permanent establishment 
may be taxed in that other State on a net basis under Article 
7, and not under Article 14 (Income from Employment), which 
applies only to income of employees. With respect to the 
enterprise's employees themselves, however, their salary 
remains subject to Article 14.
    Because this Article applies to income earned by an 
enterprise from the furnishing of personal services, the 
Article also applies to income derived by a partner resident in 
a Contracting State that is attributable to personal services 
performed in the other Contracting State through a partnership 
with a permanent establishment in that other State. Income 
which may be taxed under this Article includes all income 
attributable to the permanent establishment in respect of the 
performance of the personal services carried on by the 
partnership (whether by the partner himself, other partners in 
the partnership, or by employees assisting the partners) and 
any income from activities ancillary to the performance of 
those services (e.g., charges for facsimile services).
    The application of Article 7 to a service partnership may 
be illustrated by the following example: a partnership has five 
partners (who agree to split profits equally), four of whom are 
resident and perform personal services only in Iceland at 
Office A, and one of whom performs personal services at Office 
B, a permanent establishment in the United States. In this 
case, the four partners of the partnership resident in Iceland 
may be taxed in the United States in respect of their share of 
the income attributable to the permanent establishment, Office 
B. The services giving rise to income which may be attributed 
to the permanent establishment would include not only the 
services performed by the one resident partner, but also, for 
example, if one of the four other partners came to the United 
States and worked on an Office B matter there, the income in 
respect of those services. Income from the services performed 
by the visiting partner would be subject to tax in the United 
States regardless of whether the visiting partner actually 
visited or used Office B while performing services in the 
United States.

Paragraph 2

    Paragraph 2 provides rules for the attribution of business 
profits to a permanent establishment. The Contracting States 
will attribute to a permanent establishment the profits that it 
would have earned had it been 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.
    The ``attributable to'' concept of paragraph 2 provides an 
alternative to the analogous but somewhat different 
``effectively connected'' concept in Code section 864(c). 
Depending on the circumstances, the amount of income 
``attributable to'' a permanent establishment under Article 7 
may be greater or less than the amount of income that would be 
treated as ``effectively connected'' to a U.S. trade or 
business under Code section 864. In particular, in the case of 
financial institutions, the use of internal dealings to 
allocate income within an enterprise may produce results under 
Article 7 that are significantly different than the results 
under the effectively connected income rules. For example, 
income from interbranch notional principal contracts may be 
taken into account under Article 7, notwithstanding that such 
transactions may be ignored for purposes of U.S. domestic law.
    The profits attributable to a permanent establishment may 
be from sources within or without a Contracting State. However, 
the business profits attributable to a permanent establishment 
include only those profits derived from the assets used, risks 
assumed, and activities performed by the permanent 
establishment.
    Paragraph 2 of the Protocol confirms that the arm's length 
method of paragraphs 2 and 3 consists of applying the OECD 
Transfer Pricing Guidelines, but taking into account the 
different economic and legal circumstances of a single legal 
entity (as opposed to separate but associated enterprises). 
Thus, any of the methods used in the Transfer Pricing 
Guidelines, including profits methods, may be used as 
appropriate and in accordance with the Transfer Pricing 
Guidelines.
    However, the use of the Transfer Pricing Guidelines applies 
only for purposes of attributing profits within the legal 
entity. It does not create legal obligations or other tax 
consequences that would result from transactions having 
independent legal significance.
    One example of the different circumstances of a single 
legal entity is that an entity that operates through branches 
rather than separate subsidiaries generally 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). 
This is the reason that most commercial banks and some 
insurance companies operate through branches rather than 
subsidiaries. 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 the case of an enterprise 
that operates through separate entities, since each entity will 
have to be separately capitalized or will have to compensate 
another entity for providing capital (usually through a 
guarantee).
    Under U.S. domestic regulations, internal ``transactions'' 
generally are not recognized because they do not have legal 
significance. In contrast, the Convention provides that such 
internal dealings may be used to attribute income to a 
permanent establishment in cases where the dealings accurately 
reflect the allocation of risk within the enterprise. One 
example is that of global trading in securities. In many cases, 
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 Convention, 
such a bank may also use such swap transactions as a means of 
attributing income between the branches, if use of that method 
is the ``best method'' within the meaning of regulation section 
1.482-1(c). The books of a branch will not be respected, 
however, when the results are inconsistent with a functional 
analysis. So, for example, income from a transaction that is 
booked in a particular branch (or home office) will not be 
treated as attributable to that location if the sales and risk 
management functions that generate the income are performed in 
another location.
    Because the use of profits methods is permissible under 
paragraph 2, it is not necessary for the Convention to include 
a provision corresponding to paragraph 4 of Article 7 of the 
OECD Model.

Paragraph 3

    Paragraph 3 provides that in determining the business 
profits of a permanent establishment, deductions shall be 
allowed for the expenses incurred for the purposes of the 
permanent establishment, ensuring that business profits will be 
taxed on a net basis. This rule is not limited to expenses 
incurred exclusively for the purposes of the permanent 
establishment, but includes expenses incurred for the purposes 
of the enterprise as a whole, or that part of the enterprise 
that includes the permanent establishment. Deductions are to be 
allowed regardless of which accounting unit of the enterprise 
books the expenses, so long as they are incurred for the 
purposes of the permanent establishment. For example, a portion 
of the interest expense recorded on the books of the home 
office in one State may be deducted by a permanent 
establishment in the other. The amount of the expense that must 
be allowed as a deduction is determined by applying the arm's 
length principle. And, as noted above with respect to paragraph 
2 of Article 1 (General Scope), if a deduction would be allowed 
under the Code in computing the U.S. taxable income, the 
deduction also is allowed in computing taxable income under the 
Convention. However, except where the Convention provides for 
more favorable treatment, a taxpayer cannot take deductions for 
expenses in computing taxable income under the Convention 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, assume that a Bulgarian taxpayer with a permanent 
establishment in the United States borrows $100 to purchase 
U.S. tax exempt bonds, and that the $100 of tax-exempt bonds 
and the $100 of related debt would be treated as assets and 
liabilities of the permanent establishment. For purposes of 
computing the profits attributable to the permanent 
establishment under the Convention, both the tax exempt 
interest from the bonds and the interest expense from the 
related debt would be excluded.
    As noted above, paragraph the Convention provides that the 
OECD Transfer Pricing Guidelines apply, by analogy, in 
determining the profits attributable to a permanent 
establishment. Accordingly, 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. The method to be used in calculating that amount will 
depend on the terms of the arrangements between the branches 
and head office. For example, the enterprise could have a 
policy, expressed in writing, under which each business unit 
could use the services of lawyers employed by the head office. 
At the end of each year, the costs of employing the lawyers 
would be charged to each business unit according to the amount 
of services used by that business unit during the year. Since 
this appears to be a kind of cost-sharing arrangement and the 
allocation of costs is based on the benefits received by each 
business unit, such a cost allocation would be an acceptable 
means of determining a permanent establishment's deduction for 
legal expenses. Alternatively, the head office could agree to 
employ lawyers at its own risk, and to charge an arm's length 
price for legal services performed for a particular business 
unit. If the lawyers were under-utilized, and the ``fees'' 
received from the business units were less than the cost of 
employing the lawyers, then the head office would bear the 
excess cost. If the ``fees'' exceeded the cost of employing the 
lawyers, then the head office would keep the excess to 
compensate it for assuming the risk of employing the lawyers. 
If the enterprise acted in accordance with this agreement, this 
method would be an acceptable alternative method for 
calculating a permanent establishment's deduction for legal 
expenses.
    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. To 
the extent that the permanent establishment has not been 
attributed capital for profit attribution purposes, a 
Contracting State 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. The method prescribed by U.S. 
domestic law for making this attribution is found in Treas. 
Reg. section 1.882-5. Both section 1.882-5 and the method 
prescribed the Convention 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.
    However, section 1.882-5 does not take into account the 
fact that some assets create more risk for the enterprise than 
do other assets. An independent enterprise would need less 
capital to support a perfectly-hedged U.S. Treasury security 
than it would need to support an equity security or other asset 
with significant market and/or credit risk. Accordingly, in 
some cases section 1.882-5 would require a taxpayer to allocate 
more capital to the United States, and therefore would reduce 
the taxpayer's interest deduction more, than is appropriate. To 
address these cases, the Convention allows a taxpayer to apply 
a more flexible approach that takes into account the relative 
risk of its assets in the various jurisdictions in which it 
does business. In particular, in the case of financial 
institutions other than insurance companies, the amount of 
capital attributable to a permanent establishment is determined 
by allocating the institution's total equity between its 
various offices on the basis of the proportion of the financial 
institution's risk-weighted assets attributable to each of 
them. This recognizes the fact that financial institutions are 
in many cases required to risk-weight their assets for 
regulatory purposes and, in other cases, will do so for 
business reasons even if not required to do so by regulators. 
However, risk-weighting is more complicated than the method 
prescribed by section 1.882-5. Accordingly, to ease this 
administrative burden, taxpayers may choose to apply the 
principles of Treas. Reg. section 1.882-5(c) to determine the 
amount of capital allocable to its U.S. permanent 
establishment, in lieu of determining its allocable capital 
under the risk-weighted capital allocation method provided by 
the Convention, even if it has otherwise chosen the principles 
of Article 7 rather than the effectively connected income rules 
of U.S. domestic law.

Paragraph 4

    Paragraph 4 provides that no business profits can be 
attributed to a permanent establishment merely because it 
purchases goods or merchandise for the enterprise of which it 
is a part. This paragraph is essentially identical to paragraph 
5 of Article 7 of the OECD Model. This rule applies only to an 
office that performs functions for the enterprise in addition 
to purchasing. The income attribution issue does not arise if 
the sole activity of the office is the purchase of goods or 
merchandise because such activity does not give rise to a 
permanent establishment under Article 5 (Permanent 
Establishment). A common situation in which paragraph 4 is 
relevant is one in which a permanent establishment purchases 
raw materials for the enterprise's manufacturing operation 
conducted outside the United States and sells the manufactured 
product. While business profits may be attributable to the 
permanent establishment with respect to its sales activities, 
no profits are attributable to it with respect to its 
purchasing activities.

Paragraph 5

    Paragraph 5 provides that profits shall be determined by 
the same method each year, unless there is good reason to 
change the method used. This rule assures consistent tax 
treatment over time for permanent establishments. It limits the 
ability of both the Contracting State and the enterprise to 
change accounting methods to be applied to the permanent 
establishment. It does not, however, restrict a Contracting 
State from imposing additional requirements, such as the rules 
under Code section 481, to prevent amounts from being 
duplicated or omitted following a change in accounting method. 
Such adjustments may be necessary, for example, if the taxpayer 
switches from using the domestic rules under section 864 in one 
year to using the rules of Article 7 in the next. Also, if the 
taxpayer switches from Convention-based rules to U.S. domestic 
rules, it may need to meet certain deadlines for making 
elections that are not necessary when applying the rules of the 
Convention.

Paragraph 6

    Paragraph 6 coordinates the provisions of Article 7 and 
other provisions of the Convention. Under this paragraph, when 
business profits include items of income that are dealt with 
separately under other articles of the Convention, the 
provisions of those articles will, except when they 
specifically provide to the contrary, take precedence over the 
provisions of Article 7. For example, the taxation of dividends 
will be determined by the rules of Article 10 (Dividends), and 
not by Article 7, except where, as provided in paragraph 6 of 
Article 10, the dividend is attributable to a permanent 
establishment. In the latter case the provisions of Article 7 
apply. Thus, an enterprise of one State deriving dividends from 
the other State may not rely on Article 7 to exempt those 
dividends from tax at source if they are not attributable to a 
permanent establishment of the enterprise in the other State. 
By the same token, if the dividends are attributable to a 
permanent establishment in the other State, the dividends may 
be taxed on a net income basis at the source State full 
corporate tax rate, rather than on a gross basis under Article 
10.
    As provided in Article 8 (Shipping and Air Transport), 
income derived from shipping and air transport activities in 
international traffic described in that Article is taxable only 
in the country of residence of the enterprise regardless of 
whether it is attributable to a permanent establishment 
situated in the source State.

Paragraph 7

    Paragraph 7 incorporates into the Convention the rule of 
Code section 864(c)(6). Like the Code section on which it is 
based, paragraph 7 provides that any income or gain 
attributable to a permanent establishment during its existence 
is taxable in the Contracting State where the permanent 
establishment is situated, even if the payment of that income 
or gain is deferred until after the permanent establishment 
ceases to exist. This rule applies with respect to paragraphs 1 
and 2 of Article 7 (Business Profits), paragraph 6 of Article 
10, paragraph 4 of Article 11 (Interest), paragraph 3 of 
Articles 12 (Royalties) and 13 (Capital Gains) and paragraph 2 
of Article 20 (Other Income).
    The effect of this rule can be illustrated by the following 
example. Assume a company that is a resident of Iceland and 
that maintains a permanent establishment in the United States 
winds up the permanent establishment's business and sells the 
permanent establishment's inventory and assets to a U.S. buyer 
at the end of year 1 in exchange for an interest-bearing 
installment obligation payable in full at the end of year 3. 
Despite the fact that Article 13's threshold requirement for 
U.S. taxation is not met in year 3 because the company has no 
permanent establishment in the United States, the United States 
may tax the deferred income payment recognized by the company 
in year 3.

Relationship to Other Articles

    This Article is subject to the saving clause of paragraph 4 
of Article 1 (General Scope) of the Model. Thus, if a citizen 
of the United States who is a resident of Iceland under the 
treaty 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 the 
provision of paragraph 1 of this Article which would exempt the 
income from U.S. tax.
    The benefits of this Article are also subject to Article 21 
(Limitation on Benefits). Thus, an enterprise of Iceland that 
derives income effectively connected with a U.S. trade or 
business may not claim the benefits of Article 7 unless the 
resident carrying on the enterprise qualifies for such benefits 
under Article 21.
    As provided in paragraph 3 of the Protocol, Articles 7 and 
23 (Non-Discrimination) shall not prevent Iceland from 
continuing to tax permanent establishments of United States 
insurance companies in accordance with Article 70, paragraph 2, 
section 3 of the Icelandic Tax Code, nor shall it prevent the 
United States from continuing to tax permanent establishments 
of Icelandic insurance companies in accordance with section 
842(b) of the Code.

                 ARTICLE 8 (SHIPPING AND AIR TRANSPORT)

    This Article governs the taxation of profits from the 
operation of ships and aircraft in international traffic. The 
term ``international traffic'' is defined in subparagraph 1(h) 
of Article 3 (General Definitions).

Paragraph 1

    Paragraph 1 provides that profits derived by an enterprise 
of a Contracting State from the operation in international 
traffic of ships or aircraft are taxable only in that 
Contracting State. Because paragraph 6 of Article 7 (Business 
Profits) defers to Article 8 with respect to shipping income, 
such income derived by a resident of one of the Contracting 
States may not be taxed in the other State even if the 
enterprise has a permanent establishment in that other State. 
Thus, if a U.S. airline has a ticket office in Iceland, Iceland 
may not tax the airline's profits attributable to that office 
under Article 7. Since entities engaged in international 
transportation activities normally will have many permanent 
establishments in a number of countries, the rule avoids 
difficulties that would be encountered in attributing income to 
multiple permanent establishments if the income were covered by 
Article 7.

Paragraph 2

    The income from the operation of ships or aircraft in 
international traffic that is exempt from tax under paragraph 1 
is defined in paragraph 2.
    In addition to income derived directly from the operation 
of ships and aircraft in international traffic, this definition 
also includes certain items of rental income. First, income of 
an enterprise of a Contracting State from the rental of ships 
or aircraft on a full basis (i.e., with crew) is income of the 
lessor from the operation of ships and aircraft in 
international traffic and, therefore, is exempt from tax in the 
other Contracting State under paragraph 1. Also, paragraph 2 
encompasses income from the lease of ships or aircraft on a 
bareboat basis (i.e., without crew), either when the income is 
incidental to other income of the lessor from the operation of 
ships or aircraft in international traffic, or when the ships 
or aircraft are operated in international traffic by the 
lessee. If neither of those two conditions apply, income from 
the bareboat rentals would constitute business profits. The 
coverage of Article 8 is therefore broader than that of Article 
8 of the OECD Model, which covers bareboat leasing only when it 
is incidental to other income of the lessor from the operation 
of ships of aircraft in international traffic.
    Paragraph 2 also clarifies, consistent with the Commentary 
to Article 8 of the OECD Model, that income earned by an 
enterprise from the inland transport of property or passengers 
within either Contracting State falls within Article 8 if the 
transport is undertaken as part of the international transport 
of property or passengers by the enterprise. Thus, if a U.S. 
shipping company contracts to carry property from Iceland to a 
U.S. city and, as part of that contract, it transports the 
property by truck from its point of origin to an airport in 
Iceland (or it contracts with a trucking company to carry the 
property to the airport) the income earned by the U.S. shipping 
company from the overland leg of the journey would be taxable 
only in the United States. Similarly, Article 8 also would 
apply to all of the income derived from a contract for the 
international transport of goods, even if the goods were 
transported to the port by a lighter, not by the vessel that 
carried the goods in international waters.
    Finally, certain non-transport activities that are an 
integral part of the services performed by a transport company, 
or are ancillary to the enterprise's operation of ships or 
aircraft in international traffic, are understood to be covered 
in paragraph 1, though they are not specified in paragraph 2. 
These include, for example, the provision of goods and services 
by engineers, ground and equipment maintenance and staff, cargo 
handlers, catering staff and customer services personnel. Where 
the enterprise provides such goods to, or performs services 
for, other enterprises and such activities are directly 
connected with or ancillary to the enterprise's operation of 
ships or aircraft in international traffic, the profits from 
the provision of such goods and services to other enterprises 
will fall under this paragraph.
    For example, enterprises engaged in the operation of ships 
or aircraft in international traffic may enter into pooling 
arrangements for the purposes of reducing the costs of 
maintaining facilities needed for the operation of their ships 
or aircraft in other countries. For instance, where an airline 
enterprise agrees (for example, under an International Airlines 
Technical Pool agreement) to provide spare parts or maintenance 
services to other airlines landing at a particular location 
(which allows it to benefit from these services at other 
locations), activities carried on pursuant to that agreement 
will be ancillary to the operation of aircraft in international 
traffic by the enterprise.
    Also, advertising that the enterprise may do for other 
enterprises in magazines offered aboard ships or aircraft that 
it operates in international traffic or at its business 
locations, such as ticket offices, is ancillary to its 
operation of these ships or aircraft. Profits generated by such 
advertising fall within this paragraph. Income earned by 
concessionaires, however, is not covered by Article 8. These 
interpretations of paragraph 1 also are consistent with the 
Commen*tary to Article 8 of the OECD Model.

Paragraph 3

    Under this paragraph, profits of an enterprise of a 
Contracting State from the use, maintenance or rental of 
containers (including equipment for their transport) used in 
international traffic are exempt from tax in the other 
Contracting State. This result obtains under paragraph 3 
regardless of whether the recipient of the income is engaged in 
the operation of ships or aircraft in international traffic, 
and regardless of whether the enterprise has a permanent 
establishment in the other Contracting State. Only income from 
the use, maintenance or rental of containers that is incidental 
to other income from international traffic is covered by 
Article 8 of the OECD Model.

Paragraph 4

    This paragraph clarifies that the provisions of paragraphs 
1 and 3 also apply to profits derived by an enterprise of a 
Contracting State from participation in a pool, joint business 
or international operating agency. This refers to various 
arrangements for international cooperation by carriers in 
shipping and air transport. For example, airlines from two 
countries may agree to share the transport of passengers 
between the two countries. They each will fly the same number 
of flights per week and share the revenues from that route 
equally, regardless of the number of passengers that each 
airline actually transports. Paragraph 4 makes clear that with 
respect to each carrier the income dealt with in the Article is 
that carrier's share of the total transport, not the income 
derived from the passengers actually carried by the airline. 
This paragraph corresponds to paragraph 4 of Article 8 of the 
OECD Model.

Relationship to Other Articles

    The taxation of gains from the alienation of ships, 
aircraft or containers is not dealt with in this Article but in 
paragraph 4 of Article 13 (Capital Gains).
    As with other benefits of the Convention, the benefit of 
exclusive residence country taxation under Article 8 is 
available to an enterprise only if it is entitled to benefits 
under Article 21 (Limitation on Benefits).
    This Article also is subject to the saving clause of 
paragraph 4 of Article 1 (General Scope) of the Model. Thus, if 
a citizen of the United States who is a resident of Iceland 
derives profits from the operation of ships or aircraft in 
international traffic, notwithstanding the exclusive residence 
country taxation in paragraph 1 of Article 8, 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 as part of the worldwide income of the citizen. 
(This is an unlikely situation, however, because non-tax 
considerations (e.g., insurance) generally result in shipping 
activities being carried on in corporate form.)

                   ARTICLE 9 (ASSOCIATED ENTERPRISES)

    This Article incorporates in the Convention the arm's-
length principle reflected in the U.S. domestic transfer 
pricing provisions, particularly Code section 482. It provides 
that when related enterprises engage in a transaction on terms 
that are not arm's-length, the Contracting States may make 
appropriate adjustments to the taxable income and tax liability 
of such related enterprises to reflect what the income and tax 
of these enterprises with respect to the transaction would have 
been had there been an arm's-length relationship between them.
    Paragraph 1
    This paragraph is essentially the same as its counterpart 
in the U.S. and OECD Models. It addresses the situation where 
an enterprise of a Contracting State is related to an 
enterprise of the other Contracting State, and there are 
arrangements or conditions imposed between the enterprises in 
their commercial or financial relations that are different from 
those that would have existed in the absence of the 
relationship. Under these circumstances, the Contracting States 
may adjust the income (or loss) of the enterprise to reflect 
what it would have been in the absence of such a relationship.
    The paragraph identifies the relationships between 
enterprises that serve as a prerequisite to application of the 
Article. As the Commentary to the OECD Model makes clear, the 
necessary element in these relationships is effective control, 
which is also the standard for purposes of section 482. Thus, 
the Article applies if an enterprise of one State participates 
directly or indirectly in the management, control, or capital 
of the enterprise of the other State. Also, the Article applies 
if any third person or persons participate directly or 
indirectly in the management, control, or capital of 
enterprises of different States. For this purpose, all types of 
control are included, i.e., whether or not legally enforceable 
and however exercised or exercisable.
    The fact that a transaction is entered into between such 
related enterprises does not, in and of itself, mean that a 
Contracting State may adjust the income (or loss) of one or 
both of the enterprises under the provisions of this Article. 
If the conditions of the transaction are consistent with those 
that would be made between independent persons, the income 
arising from that trans-action should not be subject to 
adjustment under this Article.
    Similarly, the fact that associated enterprises may have 
concluded arrangements, such as cost sharing arrangements or 
general services agreements, is not in itself an indication 
that the two enterprises have entered into a non-arm's-length 
transaction that should give rise to an adjustment under 
paragraph 1. Both related and unrelated parties enter into such 
arrangements (e.g., joint venturers may share some development 
costs). As with any other kind of transaction, when related 
parties enter into an arrangement, the specific arrangement 
must be examined to see whether or not it meets the arm's-
length standard. In the event that it does not, an appropriate 
adjustment may be made, which may include modifying the terms 
of the agreement or re-characterizing the transaction to 
reflect its substance.
    It is understood that the ``commensurate with income'' 
standard for determining appropriate transfer prices for 
intangibles, added to Code section 482 by the Tax Reform Act of 
1986, was designed to operate consistently with the arm's-
length standard. The implementation of this standard in the 
section 482 regulations is in accordance with the general 
principles of paragraph 1 of Article 9 of the Convention, as 
interpreted by the OECD Transfer Pricing Guidelines.
    This Article also permits tax authorities to deal with thin 
capitalization issues. They may, in the context of Article 9, 
scrutinize more than the rate of interest charged on a loan 
between related persons. They also may examine the capital 
structure of an enterprise, whether a payment in respect of 
that loan should be treated as interest, and, if it is treated 
as interest, under what circumstances interest deductions 
should be allowed to the payor. Paragraph 2 of the Commentary 
to Article 9 of the OECD Model, together with the U.S. 
observation set forth in paragraph 15, sets forth a similar 
understanding of the scope of Article 9 in the context of thin 
capitalization.

Paragraph 2

    When a Contracting State has made an adjustment that is 
consistent with the provisions of paragraph 1, and the other 
Contracting State agrees that the adjustment was appropriate to 
reflect arm's-length conditions, that other Contracting State 
is obligated to make a correlative adjustment (sometimes 
referred to as a ``corresponding adjustment'') to the tax 
liability of the related person in that other Contracting 
State. Although the OECD Model does not specify that the other 
Contracting State must agree with the initial adjustment before 
it is obligated to make the correlative adjustment, the 
Commentary makes clear that the paragraph is to be read that 
way.
    As explained in the Commentary to Article 9 of the OECD 
Model, Article 9 leaves the treatment of ``secondary 
adjustments'' to the laws of the Contracting States. When an 
adjustment under Article 9 has been made, one of the parties 
will have in its possession funds that it would not have had at 
arm's length. The question arises as to how to treat these 
funds. In the United States the general practice is to treat 
such funds as a dividend or contribution to capital, depending 
on the relationship between the parties. Under certain 
circumstances, the parties may be permitted to restore the 
funds to the party that would have the funds had the 
transactions been entered into on arm's length terms, and to 
establish an account payable pending restoration of the funds. 
See  Rev. Proc. 99-32, 1999-2 C.B. 296.
    The Contracting State making a secondary adjustment will 
take the other provisions of the Convention, where relevant, 
into account. For example, if the effect of a secondary 
adjustment is to treat a U.S. corporation as having made a 
distribution of profits to its parent corporation in the other 
Contracting State, the provisions of Article 10 (Dividends) 
will apply, and the United States may impose a 5 percent 
withholding tax on the dividend. Also, if under Article 22 
(Relief from Double Taxation) the other State generally gives a 
credit for taxes paid with respect to such dividends, it would 
also be required to do so in this case.
    The competent authorities are authorized by paragraph 3 of 
Article 24 (Mutual Agreement Procedure) to consult, if 
necessary, to resolve any differences in the application of 
these provisions. For example, there may be a disagreement over 
whether an adjustment made by a Contracting State under 
paragraph 1 was appropriate.
    If a correlative adjustment is made under paragraph 2, it 
is to be implemented, pursuant to paragraph 2 of Article 24, 
notwithstanding any time limits or other procedural limitations 
in the law of the Contracting State making the adjustment. If a 
taxpayer has entered a closing agreement (or other written 
settlement) with the United States prior to bringing a case to 
the competent authorities, the U.S. competent authority will 
endeavor only to obtain a correlative adjustment from Iceland. 
See  Rev. Proc. 2006-54, 2006-49 I.R.B.1035, Section 7.05.

Relationship to Other Articles

    The saving clause of paragraph 4 of Article 1 (General 
Scope) does not apply to paragraph 2 of Article 9 by virtue of 
an exception to the saving clause in subparagraph 5(a) of 
Article 1. Thus, even if the statute of limitations has run, a 
refund of tax can be made in order to implement a correlative 
adjustment. Statutory or procedural limitations, however, 
cannot be overridden to impose additional tax, because 
paragraph 2 of Article 1 provides that the Convention cannot 
restrict any statutory benefit.

                         ARTICLE 10 (DIVIDENDS)

    Article 10 provides rules for the taxation of dividends 
paid by a company that is a resident of one Contracting State 
to a beneficial owner that is a resident of the other 
Contracting State. The Article provides for full residence 
State taxation of such dividends and a limited source-State 
right to tax. Article 10 also provides rules for the imposition 
of a tax on branch profits by the State of source. Finally, the 
article prohibits a State from imposing taxes on a company 
resident in the other Contracting State, other than a branch 
profits tax, on undistributed earnings.

Paragraph 1

    The right of a shareholder's country of residence to tax 
dividends arising in the source country is preserved by 
paragraph 1, which permits a Contracting State to tax its 
residents on dividends paid to them by a company that is a 
resident of the other Contracting State. For dividends from any 
other source paid to a resident, Article 20 (Other Income) 
grants the residence country exclusive taxing jurisdiction 
(other than for dividends attributable to a permanent 
establishment in the other State).

Paragraph 2

    The State of source also may tax dividends beneficially 
owned by a resident of the other State, subject to the 
limitations of paragraphs 2 and 3. Paragraph 2 generally limits 
the rate of withholding tax in the State of source on dividends 
paid by a company resident in that State to 15 percent of the 
gross amount of the dividend. If, however, the beneficial owner 
of the dividend is a company resident in the other State and 
owns directly shares representing at least 10 percent of the 
share capital, as represented as voting power of the company 
paying the dividend, then the rate of withholding tax in the 
State of source is limited to 5 percent of the gross amount of 
the dividend. Shares are considered voting shares if they 
provide the power to elect, appoint or replace any person 
vested with the powers ordinarily exercised by the board of 
directors of a U.S. corporation.
    The benefits of paragraph 2 may be granted at the time of 
payment by means of reduced rate of withholding tax at source. 
It also is consistent with the paragraph for tax to be withheld 
at the time of payment at full statutory rates, and the treaty 
benefit to be granted by means of a subsequent refund so long 
as such procedures are applied in a reasonable manner.
    The determination of whether the ownership threshold for 
subparagraph 2(a) is met for purposes of the 5 percent maximum 
rate of withholding tax is made on the date on which 
entitlement to the dividend is determined. Thus, in the case of 
a dividend from a U.S. company, the determination of whether 
the ownership threshold is met generally would be made on the 
dividend record date.
    Paragraph 2 does not affect the taxation of the profits out 
of which the dividends are paid. The taxation by a Contracting 
State of the income of its resident companies is governed by 
the internal law of the Contracting State, subject to the 
provisions of paragraph 4 of Article 23 (Non-Discrimination).
    The term ``beneficial owner'' is not defined in the 
Convention, and is, therefore, defined as under the internal 
law of the country imposing tax (i.e., the source country). The 
beneficial owner of the dividend for purposes of Article 10 is 
the person to which the dividend income is attributable for tax 
purposes under the laws of the source State. Thus, if a 
dividend paid by a corporation that is a resident of one of the 
States (as determined under Article 4 (Resident)) is received 
by a nominee or agent that is a resident of the other State on 
behalf of a person that is not a resident of that other State, 
the dividend is not entitled to the benefits of this Article. 
However, a dividend received by a nominee on behalf of a 
resident of that other State would be entitled to benefits. 
These limitations are confirmed by paragraph 12 of the 
Commentary to Article 10 of the OECD Model.
    Special rules, however, apply to shares that are held 
through fiscally transparent entities. In that case, the rules 
of paragraph 6 of Article 1 (General Scope) will apply to 
determine whether the dividends should be treated as having 
been derived by a resident of a Contracting State. Residence 
State principles shall be used to determine who derives the 
dividend, to assure that the dividends for which the source 
State grants benefits of the Convention will be taken into 
account for tax purposes by a resident of the residence State. 
Source State principles of beneficial ownership shall then 
apply to determine whether the person who derives the 
dividends, or another resident of the other Contracting State, 
is the beneficial owner of the dividend. The source State may 
conclude that the person who derives the dividend in the 
residence State is a mere nominee, agent, conduit, etc., for a 
third country resident and deny benefits of the Convention. If 
the person who derives the dividend under paragraph 6 of 
Article 1 would not be treated under the source State's 
principles for determining beneficial ownership as a nominee, 
agent, custodian, conduit, etc., that person will be treated as 
the beneficial owner of the income, profits or gains for 
purposes of the Convention.
    Assume, for instance, that a company resident in Iceland 
pays a dividend to LLC, an entity which is treated as fiscally 
transparent for U.S. tax purposes but is treated as a company 
for Icelandic tax purposes. USCo, a company incorporated in the 
United States, is the sole interest holder in LLC. Paragraph 6 
of Article 1 provides that USCo derives the dividend. Iceland's 
principles of beneficial ownership shall then be applied to 
USCo. If under the laws of Iceland USCo is found not to be the 
beneficial owner of the dividend, USCo will not be entitled to 
the benefits of Article 10 with respect to such dividend. The 
payment may be entitled to benefits, however, if USCo is found 
to be a nominee, agent, custodian or conduit for a person who 
is a resident of the United States.
    Beyond identifying the person to whom the principles of 
beneficial ownership shall be applied, the principles of 
paragraph 6 of Article 1 will also apply when determining 
whether other requirements, such as the ownership threshold of 
subparagraph 2(a) have been satisfied.
    For example, assume that IceCo, a company that is a 
resident of Iceland, owns all of the outstanding shares in 
ThirdDE, an entity that is disregarded for U.S. tax purposes 
that is resident in a third country. ThirdDE owns 100% of the 
stock of USCo. Iceland views ThirdDE as fiscally transparent 
under its domestic law, and taxes IceCo currently on the income 
derived by ThirdDE. In this case, IceCo is treated as deriving 
the dividends paid by USCo under paragraph 6 of Article 1. 
Moreover, IceCo is treated as owning the shares of USCo 
directly. The Convention does not address what constitutes 
direct ownership for purposes of Article 10. As a result, 
whether ownership is direct is determined under the internal 
law of the country imposing tax (i.e., the source country) 
unless the context otherwise requires. Accordingly, a company 
that holds stock through such an entity will generally be 
considered to directly own such stock for purposes of Article 
10.
    This result may change, however, if ThirdDE is regarded as 
non-fiscally transparent under the laws of Iceland. Assuming 
that ThirdDE is treated as non-fiscally transparent by Iceland, 
the income will not be treated as derived by a resident of 
Iceland for purposes of the Convention. However, ThirdDE may 
still be entitled to the benefits of the U.S. tax treaty, if 
any, with its country of residence.
    The same principles would apply in determining whether 
companies holding shares through fiscally transparent entities 
such as partnerships, trusts, and estates would qualify for 
benefits. As a result, companies holding shares through such 
entities may be able to claim the benefits of subparagraph 2(a) 
under certain circumstances. The lower rate applies when the 
company's proportionate share of the shares held by the 
intermediate entity meets the 10 percent threshold, and the 
company meets the requirements of Article 1(6) (i.e., the 
company's country of residence treats the intermediate entity 
as fiscally transparent) with respect to the dividend. Whether 
this ownership threshold is satisfied may be difficult to 
determine and often will require an analysis of the partnership 
or trust agreement.

Paragraph 3

    Paragraph 3 imposes limitations on the rate reductions 
provided by paragraphs 2 and 3 in the case of dividends paid by 
RIC or a REIT.
    The first sentence of subparagraph 3(a) provides that 
dividends paid by a RIC or REIT are not eligible for the 5 
percent rate of withholding tax of subparagraph 2(a).
    The second sentence of subparagraph 3(a) provides that the 
15 percent maximum rate of withholding tax of subparagraph 2(b) 
applies to dividends paid by RICs.
    The third sentence of subparagraph 3(a) provides that the 
15 percent rate of withholding tax also applies to dividends 
paid by a REIT provided that one of the three following 
conditions is met. First, the beneficial owner of the dividend 
is an individual or a pension fund, in either case holding an 
interest of not more than 10 percent in the REIT. Second, 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 5 percent of any 
class of the REIT's shares. Third, the beneficial owner of the 
dividend holds an interest in the REIT of not more than 10 
percent and the REIT is ``diversified.'' A REIT is diversified 
if the gross value of no single interest in real property held 
by the REIT exceeds 10 percent of the gross value of the REIT's 
total interest in real property. Foreclosure property is not 
considered an interest in real property, and a REIT holding a 
partnership interest is treated as owning its proportionate 
share of any interest in real property held by the partnership.
    The restrictions set out above are intended to prevent the 
use of these entities to gain inappropriate U.S. tax benefits. 
For example, a company resident in Iceland that wishes to hold 
a diversified portfolio of U.S. corporate shares could hold the 
portfolio directly and would bear a U.S. withholding tax of 15 
percent on all of the dividends that it receives. 
Alternatively, it could hold the same diversified portfolio by 
purchasing 10 percent or more of the interests in a RIC. If the 
RIC is a pure conduit, there may be no U.S. tax cost to 
interposing the RIC in the chain of ownership. Absent the 
special rule in paragraph 3, such use of the RIC could 
transform portfolio dividends, taxable in the United States 
under the Convention at a 15 percent maximum rate of 
withholding tax, into direct investment dividends taxable at a 
5 percent maximum rate of withholding tax or eligible for the 
elimination of source-country withholding tax on dividends paid 
to pension funds as provided in paragraph 4.
    Similarly, a resident of Iceland directly holding U.S. real 
property would pay U.S. tax upon the sale of the property 
either at a 30 percent rate of withholding tax on the gross 
income or at graduated rates on the net income. As in the 
preceding example, by placing the real property in a REIT, the 
investor could, absent a special rule, transform income from 
the sale of real estate into dividend income from the REIT, 
taxable at the rates provided in Article 10, significantly 
reducing the U.S. tax that otherwise would be imposed. 
Paragraph 3 prevents this result and thereby avoids a disparity 
between the taxation of direct real estate investments and real 
estate investments made through REIT conduits. In the cases in 
which paragraph 3 allows a dividend from a REIT to be eligible 
for the 15 percent rate of withholding tax, the holding in the 
REIT is not considered the equivalent of a direct holding in 
the underlying real property.

Paragraph 4

    Paragraph 4 provides that dividends beneficially owned by a 
pension scheme or employee benefits organization may not be 
taxed in the Contracting State of which the company paying the 
tax is a resident. However, the exemption provided in paragraph 
4 shall not apply if the dividends are derived from the 
carrying on of a business, directly or indirectly, by the 
pension scheme or employee benefits organization. For these 
purposes, the term ``pension scheme'' is defined in 
subparagraph 1(l) of Article 3 (General Definitions).
    The exemption is provided because pension schemes and 
employee benefits organizations normally do not pay tax (either 
through a general exemption or because reserves for future 
pension liabilities effectively offset all of the fund's 
income), and therefore cannot benefit from a foreign tax 
credit. Moreover, distributions from a pension fund generally 
do not maintain the character of the underlying income, so the 
beneficiaries of the pension are not in a position to claim a 
foreign tax credit when they finally receive the pension, in 
many cases years after the withholding tax has been paid. 
Accordingly, in the absence of this rule, the dividends would 
almost certainly be subject to unrelieved double taxation.

Paragraph 5

    Paragraph 5 defines the term dividends broadly and 
flexibly. The definition is intended to cover all arrangements 
that yield a return on an equity investment in a corporation as 
determined under the tax law of the state of source, as well as 
arrangements that might be developed in the future.
    The term includes income from shares, or other corporate 
rights that are not treated as debt under the law of the source 
State, that participate in the profits of the company. The term 
also includes income that is subjected to the same tax 
treatment as income from shares by the law of the State of 
source. Thus, a constructive dividend that results from a non-
arm's length transaction between a corporation and a related 
party is a dividend. In the case of the United States the term 
dividend includes amounts treated as a dividend under U.S. law 
upon the sale or redemption of shares or upon a transfer of 
shares in a reorganization. See,  e.g., Rev. Rul. 92-85, 1992-2 
C.B. 69 (sale of foreign subsidiary's stock to U.S. sister 
company is a deemed dividend to extent of the subsidiary's and 
sister company's earnings and profits). Further, a distribution 
from a U.S. publicly traded limited partnership, which is taxed 
as a corporation under U.S. law, is a dividend for purposes of 
Article 10. However, a distribution by a limited liability 
company is not taxable by the United States under Article 10, 
provided the limited liability company is not characterized as 
an association taxable as a corporation under U.S. law.
    Finally, a payment denominated as interest that is made by 
a thinly capitalized corporation may be treated as a dividend 
to the extent that the debt is recharacterized as equity under 
the laws of the source State.

Paragraph 6

    Paragraph 6 provides a rule for taxing dividends paid with 
respect to holdings that form part of the business property of 
a permanent establishment. In such case, the rules of Article 7 
(Business Profits) shall apply. Accordingly, the dividends will 
be taxed on a net basis using the rates and rules of taxation 
generally applicable to residents of the State in which the 
permanent establishment is located, as such rules may be 
modified by the Convention. An example of dividends paid with 
respect to the business property of a permanent establishment 
would be dividends derived by a dealer in stock or securities 
from stock or securities that the dealer held for sale to 
customers.

Paragraph 7

    The right of a Contracting State to tax dividends paid by a 
company that is a resident of the other Contracting State is 
restricted by paragraph 7 to cases in which the dividends are 
paid to a resident of that Contracting State or are 
attributable to a permanent establishment or fixed base in that 
Contracting State. Thus, a Contracting State may not impose a 
``secondary'' withholding tax on dividends paid by a 
nonresident company out of earnings and profits from that 
Contracting State
    The paragraph also restricts the right of a Contracting 
State to impose corporate level taxes on undistributed profits, 
other than a branch profits tax. The paragraph does not 
restrict a State's right to tax its resident shareholders on 
undistributed earnings of a corporation resident in the other 
State. Thus, the authority of the United States to impose taxes 
on subpart F income and on earnings deemed invested in U.S. 
property, and its tax on income of a passive foreign investment 
company that is a qualified electing fund is in no way 
restricted by this provision.

Paragraph 8

    Paragraph 8 permits a Contracting State to impose a branch 
profits tax on a company resident in the other Contracting 
State. The tax is in addition to other taxes permitted by the 
Convention. The term ``company'' is defined in subparagraph 
1(d) of Article 3 (General Definitions).
    A Contracting State may impose a branch profits tax on a 
company if the company has income attributable to a permanent 
establishment in that Contracting State, derives income from 
real property in that Contracting State that is taxed on a net 
basis under Article 6 (Income from Immovable Property (Real 
Property)), or realizes gains taxable in that State under 
paragraph 1 of Article 13 (Capital Gains). In the case of the 
United States, the imposition of such tax is limited, however, 
to the portion of the aforementioned items of income that 
represents the amount of such income that is the ``dividend 
equivalent amount.'' This is consistent with the relevant rules 
under the U.S. branch profits tax, and the term dividend 
equivalent amount is defined in paragraph 4 of the Protocol as 
that portion of the income mentioned in paragraph 7 of Article 
10 that is comparable to the amount that would be distributed 
as a dividend if such income were earned by a subsidiary 
incorporated in the United States. For any year, a foreign 
corporation's dividend equivalent amount is equal to the after-
tax earnings attributable to the foreign corporation's (i) 
income attributable to a permanent establishment in the United 
States, (ii) income from real property in the United States 
that is taxed on a net basis under Article 6 (Income from 
Immovable Property (Real Property)), and (iii) gain from a real 
property interest taxable by the United States under paragraph 
1 of Article 13 (Capital Gains), reduced by any increase in the 
foreign corporation's net investment in U.S. assets or 
increased by any reduction in the foreign corporation's net 
investment in U.S. assets.
    The dividend equivalent amount for any year approximates 
the dividend that a U.S. branch office would have paid during 
the year if the branch had been operated as a separate U.S. 
subsidiary company. If Iceland also imposes a branch profits 
tax, the base of its tax must be limited to an amount that is 
analogous to the dividend equivalent amount.
    As discussed in the Technical Explanations to Articles 1(2) 
and 7(2), consistency principles require that a taxpayer may 
not mix and match the rules of the Code and the Convention in 
an inconsistent manner. In the context of the branch profits 
tax, the consistency requirement means that an enterprise that 
uses the principles of Article 7 to determine its net taxable 
income also must use the principles in determining the dividend 
equivalent amount. Similarly, an enterprise that uses U.S. 
domestic law to determine its net taxable income must also use 
U.S. domestic law in complying with the branch profits tax. As 
in the case of Article 7, if an enterprise switches between 
domestic law and treaty principles from year to year, it will 
need to make appropriate adjustments or recapture amounts that 
otherwise might go untaxed.

Paragraph 9

    Paragraph 9 provides that the branch profits tax shall not 
be imposed at a rate exceeding the direct investment dividend 
withholding rate of five percent.

Relationship to Other Articles

    Notwithstanding the foregoing limitations on source country 
taxation of dividends, the saving clause of paragraph 4 of 
Article 1 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 Convention had not come into 
effect.
    The benefits of this Article are also subject to the 
provisions of Article 21 (Limitation on Benefits). Thus, if a 
resident of the other Contracting State is the beneficial owner 
of dividends paid by a U.S. corporation, the shareholder must 
qualify for treaty benefits under at least one of the tests of 
Article 21 in order to receive the benefits of this Article.

                         ARTICLE 11 (INTEREST)

    Article 11 specifies the taxing jurisdictions over interest 
income of the States of source and residence and defines the 
terms necessary to apply the Article.

Paragraph 1

    Paragraph 1 generally grants to the State of residence the 
exclusive right to tax interest beneficially owned by its 
residents and arising in the other Contracting State.
    The term ``beneficial owner'' is not defined in the 
Convention, and is, therefore, defined under the internal law 
of the State of source. The beneficial owner of the interest 
for purposes of
    Article 11 is the person to which the income is 
attributable under the laws of the source State. Thus, if 
interest arising in a Contracting State is received by a 
nominee or agent that is a resident of the other State on 
behalf of a person that is not a resident of that other State, 
the interest is not entitled to the benefits of Article 11. 
However, interest received by a nominee on behalf of a resident 
of that other State would be entitled to benefits. These 
limitations are confirmed by paragraph 9 of the OECD Commentary 
to Article 11.

Paragraph 2

    The term ``interest'' as used in Article 11 is defined in 
paragraph 2 to include, inter alia, income from debt claims of 
every kind, whether or not secured by a mortgage. Penalty 
charges for late payment are excluded from the definition of 
interest. Interest that is paid or accrued subject to a 
contingency is within the ambit of Article 11. This includes 
income from a debt obligation carrying the right to participate 
in profits. The term does not, however, include amounts that 
are treated as dividends under Article 10 (Dividends).
    The term interest also includes amounts subject to the same 
tax treatment as income from money lent under the law of the 
State in which the income arises. Thus, for purposes of the 
Convention, amounts that the United States will treat as 
interest include (i) the difference between the issue price and 
the stated redemption price at maturity of a debt instrument 
(i.e., original issue discount (``OID'')), which may be wholly 
or partially realized on the disposition of a debt instrument 
(section 1273), (ii) amounts that are imputed interest on a 
deferred sales contract (section 483), (iii) amounts treated as 
interest or OID under the stripped bond rules (section 1286), 
(iv) amounts treated as original issue discount under the 
below-market interest rate rules (section 7872), (v) a 
partner's distributive share of a partnership's interest income 
(section 702), (vi) the interest portion of periodic payments 
made under a ``finance lease'' or similar contractual 
arrangement that in substance is a borrowing by the nominal 
lessee to finance the acquisition of property, (vii) amounts 
included in the income of a holder of a residual interest in a 
REMIC (section 860E), because these amounts generally are 
subject to the same taxation treatment as interest under U.S. 
tax law, and (viii) interest with respect to notional principal 
contracts that are re-characterized as loans because of a 
``substantial non-periodic payment.''

Paragraph 3

    Paragraph 3 provides an exception to the exclusive 
residence taxation rule of paragraph 1 and the source-country 
gross taxation rule of paragraph 5 in cases where the 
beneficial owner of the interest carries on business through a 
permanent establishment in the State of source situated in that 
State and the interest is attributable to that permanent 
establishment. In such cases the provisions of Article 7 
(Business Profits) will apply and the State of source will 
retain the right to impose tax on such interest income.
    In the case of a permanent establishment that once existed 
in the State but that no longer exists, the provisions of 
paragraph 3 also apply, by virtue of paragraph 7 of Article 7, 
to interest that would be attributable to such a permanent 
establishment or fixed base if it did exist in the year of 
payment or accrual. See  the Technical Explanation of paragraph 
7 of Article 7.

Paragraph 4

    Paragraph 4 provides that in cases involving special 
relationships between the payor and the beneficial owner of 
interest income, Article 11 applies only to that portion of the 
total interest payments that would have been made absent such 
special relationships (i.e., an arm's length interest payment). 
Any excess amount of interest paid remains taxable according to 
the laws of the United States and Iceland, respectively, with 
due regard to the other provisions of the Convention. Thus, if 
the excess amount would be treated under the source country's 
law as a distribution of profits by a corporation, such amount 
could be taxed as a dividend rather than as interest, but the 
tax would be subject, if appropriate, to the rate limitations 
of paragraph 2 of Article 10.
    The term ``special relationship'' is not defined in the 
Convention. In applying this paragraph the United States 
considers the term to include the relationships described in 
Article 9, which in turn corresponds to the definition of 
``control'' for purposes of section 482 of the Code.
    This paragraph does not address cases where, owing to a 
special relationship between the payer and the beneficial owner 
or between both of them and some other person, the amount of 
the interest is less than an arm's-length amount. In those 
cases a transaction may be characterized to reflect its 
substance and interest may be imputed consistent with the 
definition of interest in paragraph 3. The United States would 
apply section 482 or 7872 of the Code to determine the amount 
of imputed interest in those cases.

Paragraph 5

    Paragraph 5 provides anti-abuse exceptions to the source-
country exemption in paragraph 1 for two classes of interest 
payments.
    The first class of interest, dealt with in subparagraph 
5(a) is so-called ``contingent interest.'' Under this 
provision, interest arising in a Contracting State that is 
determined by reference to the receipts, sales, income, profits 
or other cash flow of the debtor or a related person, to any 
change in the value of any property of the debtor or a related 
person or to any dividend, partnership distribution or similar 
payment made by the debtor or a related person, and paid to a 
resident of the other State may also be taxed in the 
Contracting State. Any such interest may be taxed in that 
Contracting State according to the laws of that State. However, 
if the beneficial owner is a resident of the other Contracting 
State, the gross amount of the interest may be taxed at a rate 
not exceeding 15 percent.
    The second class of interest is dealt with in subparagraph 
5(b). This exception is consistent with the policy of Code 
sections 860E(e) and 860G(b) that excess inclusions with 
respect to a real estate mortgage investment conduit (REMIC) 
should bear full U.S. tax in all cases. Without a full tax at 
source foreign purchasers of residual interests would have a 
competitive advantage over U.S. purchasers at the time these 
interests are initially offered. Also, absent this rule, the 
U.S. fisc would suffer a revenue loss with respect to mortgages 
held in a REMIC because of opportunities for tax avoidance 
created by differences in the timing of taxable and economic 
income produced by these interests.

Relationship to Other Articles

    Notwithstanding the foregoing limitations on source country 
taxation of interest, the saving clause of paragraph 4 of 
Article 1 (General Scope) permits the United States to tax 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 Convention had not come into force.
    As with other benefits of the Convention, the benefits of 
Article 11 are available to a resident of the other State only 
if that resident is entitled to those benefits under the 
provisions of Article 21 (Limitation on Benefits).

                         ARTICLE 12 (ROYALTIES)

    Article 12 provides rules for the taxation of royalties 
arising in one Contracting State and paid to a beneficial owner 
that is a resident of the other Contracting State.

Paragraph 1

    Paragraph 1 generally grants to the State of residence the 
exclusive right to tax royalties beneficially owned by its 
residents and arising in the other Contracting State.
    The term ``beneficial owner'' is not defined in the 
Convention, and is, therefore, defined under the internal law 
of the State of source. The beneficial owner of the royalty for 
purposes of Article 12 is the person to which the income is 
attributable under the laws of the source State. Thus, if a 
royalty arising in a Contracting State is received by a nominee 
or agent that is a resident of the other State on behalf of a 
person that is not a resident of that other State, the royalty 
is not entitled to the benefits of Article 12. However, a 
royalty received by a nominee on behalf of a resident of that 
other State would be entitled to benefits. These limitations 
are confirmed by paragraph 4 of the OECD Commentary to Article 
12.

Paragraph 2

    Paragraph 2 provides that notwithstanding the provisions of 
paragraph 1, the following royalties may be taxed in the 
Contracting State in which they arise: royalties paid in 
consideration for the use of, or the right to use 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 royalties paid in consideration for the use of or the right 
to use a motion picture film or work on film or videotape or 
other means of reproduction for use in connection with 
television. If, however, the beneficial owner of the royalty is 
a resident of the other Contracting State, the tax may not 
exceed 5 percent of the gross amount of the royalties.

Paragraph 3

    Paragraph 2 defines the term ``royalties,'' as used in 
Article 12, to include any consideration for the use of, or the 
right to use, any copyright of literary, artistic, scientific 
or other work (such as computer software and cinematographic 
films), any patent, trademark, design or model, plan, secret 
formula or process, or for information concerning industrial, 
commercial, or scientific experience. The term ``royalties,'' 
however, does not include income from leasing personal 
property.
    The term royalties is defined in the Convention and 
therefore is generally independent of domestic law. Certain 
terms used in the definition are not defined in the Convention, 
but these may be defined under domestic tax law. For example, 
the term ``secret process or formulas'' is found in the Code, 
and its meaning has been elaborated in the context of sections 
351 and 367. See  Rev. Rul. 55-17, 1955-1 C.B. 388; Rev. Rul. 
64-56, 1964-1 C.B. 133; Rev. Proc. 69-19, 1969-2 C.B. 301.
    Consideration for the use or right to use cinematographic 
films, or works on film, tape, or other means of reproduction 
in radio or television broadcasting is specifically included in 
the definition of royalties. It is intended that, with respect 
to any subsequent technological advances in the field of radio 
or television broadcasting, consideration received for the use 
of such technology will also be included in the definition of 
royalties.
    If an artist who is resident in one Contracting State 
records a performance in the other Contracting State, retains a 
copyrighted interest in a recording, and receives payments for 
the right to use the recording based on the sale or public 
playing of the recording, then the right of such other 
Contracting State to tax those payments is governed by Article 
12. See  Boulez v. Commissioner, 83 T.C. 584 (1984), aff'd, 810 
F.2d 209 (D.C. Cir. 1986). By contrast, if the artist earns in 
the other Contracting State income covered by Article 16 
(Entertainers and Sportsmen), for example, endorsement income 
from the artist's attendance at a film screening, and if such 
income also is attributable to one of the rights described in 
Article 12 (e.g., the use of the artist's photograph in 
promoting the screening), Article 16 and not Article 12 is 
applicable to such income.
    Computer software generally is protected by copyright laws 
around the world. Under the Convention, consideration received 
for the use, or the right to use, computer software is treated 
either as royalties or as business profits, depending on the 
facts and circumstances of the transaction giving rise to the 
payment.
    The primary factor in determining whether consideration 
received for the use, or the right to use, computer software is 
treated as royalties or as business profits is the nature of 
the rights transferred. See  Treas. Reg. section 1.861-18. The 
fact that the transaction is characterized as a license for 
copyright law purposes is not dispositive. For example, a 
typical retail sale of ``shrink wrap'' software generally will 
not be considered to give rise to royalty income, even though 
for copyright law purposes it may be characterized as a 
license.
    The means by which the computer software is transferred are 
not relevant for purposes of the analysis. Consequently, if 
software is electronically transferred but the rights obtained 
by the transferee are substantially equivalent to rights in a 
program copy, the payment will be considered business profits.
    The term ``industrial, commercial, or scientific 
experience'' (sometimes referred to as ``know-how'') has the 
meaning ascribed to it in paragraph 11 et seq. of the 
Commentary to Article 12 of the OECD Model. Consistent with 
that meaning, the term may include information that is 
ancillary to a right otherwise giving rise to royalties, such 
as a patent or secret process.
    Know-how also may include, in limited cases, technical 
information that is conveyed through technical or consultancy 
services. It does not include general educational training of 
the user's employees, nor does it include information developed 
especially for the user, such as a technical plan or design 
developed according to the user's specifications. Thus, as 
provided in paragraph 11.3 of the Commentary to Article 12 of 
the OECD Model, the term ``royalties'' does not include 
payments received as consideration for after-sales service, for 
services rendered by a seller to a purchaser under a warranty, 
or for pure technical assistance.
    The term ``royalties'' also does not include payments for 
professional services (such as architectural, engineering, 
legal, managerial, medical, software development services). For 
example, income from the design of a refinery by an engineer 
(even if the engineer employed know-how in the process of 
rendering the design) or the production of a legal brief by a 
lawyer is not income from the transfer of know-how taxable 
under Article 12, but is income from services taxable under 
either Article 7 (Business Profits) or Article 14 (Income from 
Employment). Professional services may be embodied in property 
that gives rise to royalties, however. Thus, if a professional 
contracts to develop patentable property and retains rights in 
the resulting property under the development contract, 
subsequent license payments made for those rights would be 
royalties.

Paragraph 4

    This paragraph provides an exception in cases where the 
beneficial owner of the royalties carries on business through a 
permanent establishment in the state of source and the 
royalties are attributable to that permanent establishment. In 
such cases the provisions of Article 7 will apply.
    The provisions of paragraph 7 of Article 7 apply to this 
paragraph. For example, royalty income that is attributable to 
a permanent establishment and that accrues during the existence 
of the permanent establishment, but is received after the 
permanent establishment no longer exists, remains taxable under 
the provisions of Article 7, and not under this Article.

Paragraph 5

    Paragraph 5 contains the source rule for royalties. Under 
paragraph 5, royalties are treated as arising in a Contracting 
State if paid by a resident of that State. As an exception, 
royalties that are attributable to a permanent establishment in 
a Contracting State and borne by the permanent establishment 
are considered to arise in that State. Where, however, the 
payor of the royalties is not a resident of either Contracting 
State, and the royalties are not borne by a permanent 
establishment in either Contracting State, but the royalties 
are for the use of, or the right to use, in one of the 
Contracting States, any property or right described in 
paragraph 3, the royalties are deemed to arise in that State.

Paragraph 6

    Paragraph 6 provides that in cases involving special 
relationships between the payor and beneficial owner of 
royalties, Article 12 applies only to the extent the royalties 
would have been paid absent such special relationships (i.e., 
an arm's-length royalty). Any excess amount of royalties paid 
remains taxable according to the laws of the two Contracting 
States, with due regard to the other provisions of the 
Convention. If, for example, the excess amount is treated as a 
distribution of corporate profits under domestic law, such 
excess amount will be taxed as a dividend rather than as 
royalties, but the tax imposed on the dividend payment will be 
subject to the rate limitations of paragraph 2 of Article 10 
(Dividends).

1Relationship to Other Articles

    Notwithstanding the foregoing limitations on source country 
taxation of royalties, the saving clause of paragraph 4 of 
Article 1 (General Scope) permits the United States to tax 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 Convention had not come into force.
    As with other benefits of the Convention, the benefits of 
Article 12 are available to a resident of the other State only 
if that resident is entitled to those benefits under Article 21 
(Limitation on Benefits).

                       ARTICLE 13 (CAPITAL GAINS)

    Article 13 assigns either primary or exclusive taxing 
jurisdiction over gains from the alienation of property to the 
State of residence or the State of source.

Paragraph 1

    Paragraph 1 of Article 13 preserves the non-exclusive right 
of the State of source to tax from the alienation of immovable 
property (real property) situated in that State. For purposes 
of paragraph 1, in all events the term ``immovable property 
(real property) situated in the other State'' includes a United 
States real property interest in the United States, as that 
term is defined in the Internal Revenue Code on the date of 
signature of the Convention, and as amended (without changing 
the general principles of paragraph 1). Thus, the United States 
preserves its right to collect the tax imposed by section 897 
of the Code on gains derived by foreign persons from the 
disposition of United States real property interests, including 
gains arising from indirect dispositions described in section 
897(h).

Paragraph 2

    This paragraph defines the term ``immovable property (real 
property) situated in the other Contracting State.'' The term 
includes real property referred to in Article 6 (i.e., an 
interest in the real property itself), rights to assets to be 
produced by the exploration or exploitation of the seabed and 
subsoil of that other State and their natural resources, 
including rights to interests in or the benefit of such assets, 
a ``United States real property interest'' (when the United 
States is the other Contracting State under paragraph 1), and, 
as specified in subparagraph 2(d), an equivalent interest in 
immovable property (real property) situated in Iceland.
    Under section 897(c) of the Code the term ``United States 
real property interest'' includes shares in a U.S. corporation 
that owns sufficient U.S. real property interests to satisfy an 
asset-ratio test on certain testing dates. The term also 
includes certain foreign corporations that have elected to be 
treated as U.S. corporations for this purpose. Section 897(i).

Paragraph 3

    Paragraph 3 of Article 13 deals with the taxation of 
certain gains from the alienation of movable property forming 
part of the business property of a permanent establishment that 
an enterprise of a Contracting State has in the other 
Contracting State. This also includes gains from the alienation 
of such a permanent establishment (alone or with the whole 
enterprise). Such gains may be taxed in the State in which the 
permanent establishment is located.
    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, assuming that the activities of 
the partnership rise to the level of a permanent establishment. 
Rev. Rul. 91-32, 1991-1 C.B. 107. Further, under paragraph 3, 
the United States generally may tax a partner's distributive 
share of income realized by a partnership on the disposition of 
movable property forming part of the business property of the 
partnership in the United States.
    The gains subject to paragraph 3 may be taxed in the State 
in which the permanent establishment is located, regardless of 
whether the permanent establishment exists at the time of the 
alienation. This rule incorporates the rule of section 
864(c)(6) of the Code. Accordingly, income that is attributable 
to a permanent establishment, but that is deferred and received 
after the permanent establishment no longer exists, may 
nevertheless be taxed by the State in which the permanent 
establishment was located.

Paragraph 4

    This paragraph limits the taxing jurisdiction of the State 
of source with respect to gains from the alienation of ships, 
aircraft or containers operated in international traffic by the 
enterprise alienating the ship or aircraft and from property 
(other than real property) pertaining to the operation or use 
of such ships, aircraft, or containers.
    Under paragraph 4, such income is taxable only in the 
Contracting State in which the alienator is resident. 
Notwithstanding paragraph 3, the rules of this paragraph apply 
even if the income is attributable to a permanent establishment 
maintained by the enterprise in the other Contracting State. 
This result is consistent with the allocation of taxing rights 
under Article 8 (Shipping and Air Transport).

Paragraph 5

    Paragraph 5 grants to the State of residence of the 
alienator the exclusive right to tax gains from the alienation 
of property other than property referred to in paragraphs 1 
through 4. For example, gain derived from shares, other than 
shares described in paragraphs 2 or 3, debt instruments and 
various financial instruments, may be taxed only in the State 
of residence, to the extent such income is not otherwise 
characterized as income taxable under another article (e.g., 
Article 10 (Dividends) or Article 11 (Interest)). Similarly 
gain derived from the alienation of tangible personal property, 
other than tangible personal property described in paragraph 3, 
may be taxed only in the State of residence of the alienator.
    Gains derived by a resident of a Contracting State from 
real property located in a third state are not taxable in the 
other Contracting State, even if the sale is attributable to a 
permanent establishment located in the other Contracting State.

Paragraph 6

    Paragraph 6 sets forth a rule which permits the imposition 
of certain expatriation taxes. This rule provides that 
notwithstanding paragraph 5 a Contracting State may tax gains 
from the alienation of shares or rights in a company, the 
capital of which is wholly or partly divided into shares, and 
that is a resident of that State, if the person alienating the 
shares or rights is an individual resident in the other 
Contracting State, but only if such individual was a resident 
of the first-mentioned State at any time during the five-year 
period preceding the alienation.

Relationship to Other Articles

    Notwithstanding the foregoing limitations on taxation of 
certain gains by the State of source, the saving clause of 
paragraph 4 of Article 1 (General Scope) permits the United 
States to tax its citizens and residents as if the Convention 
had not come into effect. Thus, any limitation in this Article 
on the right of the United States to tax gains does not apply 
to gains of a U.S. citizen or resident.
    The benefits of this Article are also subject to the 
provisions of Article 21 (Limitation on Benefits). Thus, only a 
resident of a Contracting State that satisfies one of the 
conditions in Article 21 is entitled to the benefits of this 
Article.
    Additionally, the provisions of paragraph 6 shall be 
applied in conjunction with subparagraph 2(b) of Article 22 
(Relief from Double Taxation).

                  ARTICLE 14 (INCOME FROM EMPLOYMENT)

    Article 14 apportions taxing jurisdiction over remuneration 
derived by a resident of a Contracting State as an employee 
between the States of source and residence.

Paragraph 1

    The general rule of Article 14 is contained in paragraph 1. 
Remuneration derived by a resident of a Contracting State as an 
employee may be taxed by the State of residence, and the 
remuneration also may be taxed by the other Contracting State 
to the extent derived from employment exercised (i.e., services 
performed) in that other Contracting State. Paragraph 1 also 
provides that the more specific rules of Articles 15 
(Directors' Fees), 17 (Pensions, Social Security, and 
Annuities), and 19 (Government Service) apply in the case of 
employment income described in one of those articles. Thus, 
even though the State of source has a right to tax employment 
income under Article 14, it may not have the right to tax that 
income under the Convention if the income is described, for 
example, in Article 17 (Pensions, Social Security, and 
Annuities) and is not taxable in the State of source under the 
provisions of that article.
    Article 14 applies to any form of compensation for 
employment, including payments in kind. Paragraph 1.1 of the 
Commentary to Article 16 of the OECD Model now confirms that 
interpretation.
    Consistent with section 864(c)(6) of the Code, Article 14 
also applies regardless of the timing of actual payment for 
services. Consequently, a person who receives the right to a 
future payment in consideration for services rendered in a 
Contracting State would be taxable in that State even if the 
payment is received at a time when the recipient is a resident 
of the other Contracting State. Thus, a bonus paid to a 
resident of a Contracting State with respect to services 
performed in the other Contracting State with respect to a 
particular taxable year would be subject to Article 14 for that 
year even if it was paid after the close of the year. An 
annuity received for services performed in a taxable year could 
be subject to Article 14 despite the fact that it was paid in 
subsequent years. In that case, it would be necessary to 
determine whether the payment constitutes deferred 
compensation, taxable under Article 14, or a qualified pension 
subject to the rules of Article 17 (Pensions, Social Security, 
and Annuities). Article 14 also applies to income derived from 
the exercise of stock options granted with respect to services 
performed in the host State, even if those stock options are 
exercised after the employee has left the source country. If 
Article 14 is found to apply, whether such payments were 
taxable in the State where the employment was exercised would 
depend on whether the tests of paragraph 2 were satisfied in 
the year in which the services to which the payment relates 
were performed.

Paragraph 2

    Paragraph 2 sets forth an exception to the general rule 
that employment income may be taxed in the State where it is 
exercised. Under paragraph 2, the State where the employment is 
exercised may not tax the income from the employment if three 
conditions are satisfied: (a) the individual is present in the 
other Contracting State for a period or periods not exceeding 
183 days in any 12-month period that begins or ends during the 
relevant taxable year (i.e., in the United States, the calendar 
year in which the services are performed); (b) the remuneration 
is paid by, or on behalf of, an employer who is not a resident 
of that other Contracting State; and (c) the remuneration is 
not borne as a deductible expense by a permanent establishment 
that the employer has in that other State. In order for the 
remuneration to be exempt from tax in the source State, all 
three conditions must be satisfied. This exception is identical 
to that set forth in the OECD Model.
    The 183-day period in condition (a) is to be measured using 
the ``days of physical presence'' method. Under this method, 
the days that are counted include any day in which a part of 
the day is spent in the host country. (Rev. Rul. 56-24, 1956-1 
C.B. 851.) Thus, days that are counted include the days of 
arrival and departure; weekends and holidays on which the 
employee does not work but is present within the country; 
vacation days spent in the country before, during or after the 
employment period, unless the individual's presence before or 
after the employment can be shown to be independent of his 
presence there for employment purposes; and time during periods 
of sickness, training periods, strikes, etc., when the 
individual is present but not working. If illness prevented the 
individual from leaving the country in sufficient time to 
qualify for the benefit, those days will not count. Also, any 
part of a day spent in the host country while in transit 
between two points outside the host country is not counted. If 
the individual is a resident of the host country for part of 
the taxable year concerned and a nonresident for the remainder 
of the year, the individual's days of presence as a resident do 
not count for purposes of determining whether the 183-day 
period is exceeded.
    Conditions (b) and (c) are intended to ensure that a 
Contracting State will not be required to allow a deduction to 
the payor for compensation paid and at the same time to exempt 
the employee on the amount received. Accordingly, if a foreign 
person pays the salary of an employee who is employed in the 
host State, but a host State corporation or permanent 
establishment reimburses the payor with a payment that can be 
identified as a reimbursement, neither condition (b) nor (c), 
as the case may be, will be considered to have been fulfilled.
    The reference to remuneration ``borne by'' a permanent 
establishment is understood to encompass all expenses that 
economically are incurred and not merely expenses that are 
currently deductible for tax purposes. Accordingly, the 
expenses referred to include expenses that are capitalizable as 
well as those that are currently deductible. Further, salaries 
paid by residents that are exempt from income taxation may be 
considered to be borne by a permanent establishment 
notwithstanding the fact that the expenses will be neither 
deductible nor capitalizable since the payor is exempt from 
tax.

Paragraph 3

    Paragraph 3 contains a special rule applicable to 
remuneration for services performed by a resident of a 
Contracting State as an employee aboard a ship or aircraft 
operated in international traffic. Such remuneration may be 
taxed only in the State of residence of the employee if the 
services are performed as a member of the regular complement of 
the ship or aircraft. The ``regular complement'' includes the 
crew. In the case of a cruise ship, for example, it may also 
include others, such as entertainers, lecturers, etc., employed 
by the shipping company to serve on the ship throughout its 
voyage. The use of the term ``regular complement'' is intended 
to clarify that a person who exercises his employment as, for 
example, an insurance salesman while aboard a ship or aircraft 
is not covered by this paragraph.
    If a U.S. citizen who is resident in Iceland performs 
services as an employee in the United States and meets the 
conditions of paragraph 2 for source country exemption, he 
nevertheless is taxable in the United States by virtue of the 
saving clause of paragraph 4 of Article 1 (General Scope), 
subject to the special foreign tax credit rule of paragraph 4 
of Article 22 (Relief from Double Taxation).

                      ARTICLE 15 (DIRECTORS' FEES)

    This Article provides that a Contracting State may tax the 
fees and other compensation paid by a company that is a 
resident of that State for services performed by a resident of 
the other Contracting State in his capacity as a director of 
the company. This rule is an exception to the more general 
rules of Articles 7 (Business Profits) and 14 (Income from 
Employment). Thus, for example, in determining whether a 
director's fee paid to a non-employee director is subject to 
tax in the country of residence of the corporation, it is not 
relevant to establish whether the fee is attributable to a 
permanent establishment in that State.
    Under this Article, a resident of one Contracting State who 
is a director of a corporation that is resident in the other 
Contracting State is subject to tax in that other State in 
respect of his directors' fees regardless of where the services 
are performed. Under U.S. law, however, services performed by a 
nonresident may not be taxed unless they are performed in the 
United States (unless that nonresident is a U.S. citizen, and 
therefore subject to the saving clause of paragraph 4 of 
Article 1 (General Scope)).

                ARTICLE 16 (ENTERTAINERS AND SPORTSMEN)

    This Article deals with the taxation in a Contracting State 
of entertainers and sportsmen resident in the other Contracting 
State from the performance of their services as such. The 
Article applies both to the income of an entertainer or 
sportsman who performs services on his own behalf and one who 
performs services on behalf of another person, either as an 
employee of that person, or pursuant to any other arrangement. 
The rules of this Article take precedence, in some 
circumstances, over those of Articles 7 (Business Profits) and 
14 (Income from Employment).
    This Article applies only with respect to the income of 
entertainers and sportsmen. Others involved in a performance or 
athletic event, such as producers, directors, technicians, 
managers, coaches, etc., remain subject to the provisions of 
Articles 7 and 14. In addition, except as provided in paragraph 
2, income earned by juridical persons is not covered by Article 
16.

Paragraph 1

    Paragraph 1 describes the circumstances in which a 
Contracting State may tax the performance income of an 
entertainer or sportsman who is a resident of the other 
Contracting State. Under the paragraph, income derived by an 
individual resident of a Contracting State from activities as 
an entertainer or sportsman exercised in the other Contracting 
State may be taxed in that other State if the amount of the 
gross receipts derived by the performer exceeds $20,000 (or its 
equivalent in Icelandic kronur) for the taxable year. The 
$20,000 includes expenses reimbursed to the individual or borne 
on his behalf. If the gross receipts exceed $20,000, the full 
amount, not just the excess, may be taxed in the State of 
performance.
    The Convention introduces the monetary threshold to 
distinguish between two groups of entertainers and athletes--
those 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, and those who earn relatively modest 
amounts and are, therefore, not easily distinguishable from 
those who earn other types of personal service income.
    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 host-country 
tax under Article 16, but would be taxable under either Article 
7 or 14, tax may be imposed under either of those Articles. 
Thus, for example, if a performer derives remuneration from his 
activities in an independent capacity, and the performer does 
not have a permanent establishment in the host State, he may be 
taxed by the host State in accordance with Article 16 if his 
remuneration exceeds $20,000 annually, despite the fact that he 
generally would be exempt from host State taxation under 
Article 7. However, a performer who receives less than the 
$20,000 threshold amount and therefore is not taxable under 
Article 16 nevertheless may be 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. For example, if 
an entertainer who is an independent contractor earns $14,000 
of income in a State for the calendar year, but the income is 
attributable to his permanent establishment in the State of 
performance, that State may tax his income under Article 7.
    Nothing shall preclude a Contracting State from withholding 
tax from such payments according to its domestic laws. However, 
if according to the provisions of this Article, such 
remuneration or income may only be taxed in the other 
Contracting State, the first-mentioned Contracting State shall 
make a refund of the tax so withheld upon a duly filed claim. 
Such claim must be filed with the tax authorities that have 
collected the withholding tax within five years after the close 
of the calendar year in which the tax was withheld.
    As explained in paragraph 9 of the Commentary to Article 17 
of the OECD Model, Article 16 of the Convention 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 Contracting State by a 
performer who is a resident of the other Contracting State from 
other than actual performance, such as royalties from record 
sales and payments for product endorsements, is not covered by 
this Article, but by other articles of the Convention, such as 
Article 12 (Royalties) or Article 7. For example, if an 
entertainer receives royalty income from the sale of live 
recordings, the royalty income would be subject to the 
provisions of Article 12, even if the performance was conducted 
in the source country, although the entertainer could be taxed 
in the source country with respect to income from the 
performance itself under Article 16 if the dollar threshold is 
exceeded.
    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. 
For instance, a fee paid to a performer for endorsement of a 
performance in which the performer will participate would be 
considered to be so closely associated with the performance 
itself that it normally would fall within Article 16. 
Similarly, a sponsorship fee paid by a business in return for 
the right to attach its name to the performance would be so 
closely associated with the performance that it would fall 
under Article 16 as well. As indicated in paragraph 9 of the 
Commentary to Article 17 of the OECD Model, however, a 
cancellation fee would not be considered to fall within Article 
16 but would be dealt with under Article 7 or 14.
    As indicated in paragraph 4 of the Commentary to Article 17 
of the OECD Model, 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.
    Consistent with Article 14, Article 16 also applies 
regardless of the timing of actual payment for services. Thus, 
a bonus paid to a resident of a Contracting State with respect 
to a performance in the other Contracting State during a 
particular taxable year would be subject to Article 16 for that 
year even if it was paid after the close of the year. The 
determination as to whether the $20,000 threshold has been 
exceeded is determined separately with respect to each year of 
payment. Accordingly, if an actor who is a resident of one 
Contracting State receives residual payments over time with 
respect to a movie that was filmed in the other Contracting 
State, the payments do not have to be aggregated from one year 
to another to determine whether the total payments have finally 
exceeded $20,000. Otherwise, residual payments received many 
years later could retroactively subject all earlier payments to 
tax by the other Contracting State. Paragraph 2
    Paragraph 2 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 
to another person. Foreign performers frequently perform in the 
United States as employees of, or under contract with, a 
company or other 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 host-country 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. The performer might arrange to 
receive further payments in a later year, when he is not 
subject to host-country tax, perhaps as dividends or 
liquidating distributions.
    Paragraph 2 seeks to prevent this type of abuse while at 
the same time protecting the taxpayers' rights to the benefits 
of the Convention when there is a legitimate employee-employer 
relationship between the performer and the person providing his 
services. 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 
Contracting State where the performer's services are exercised, 
without regard to the provisions of the Convention concerning 
business profits or income from employment (Article 14). In 
cases where paragraph 2 is applicable, the income of the 
``employer'' may be subject to tax in the host Contracting 
State even if it has no permanent establishment in the host 
country. Taxation under paragraph 2 is on the person providing 
the services of the performer. This paragraph does not affect 
the rules of paragraph 1, which applyto the performer himself. 
The income taxable by virtue of paragraph 2 is reduced to the 
extent of salary payments to the performer, which fall under 
paragraph 1.
    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.
    Paragraph 2 does not apply if it is established that 
neither the performer nor any persons related to the performer 
participate directly or indirectly in the receipts or profits 
of the person providing the services of the performer. Assume, 
for example, that a circus owned by a U.S. corporation performs 
in the other Contracting State, and promoters of the 
performance in the other State pay the circus, which, in turn, 
pays salaries to the circus performers. The circus is 
determined to have no permanent establishment in that State. 
Since the circus performers do not participate in the profits 
of the circus, but merely receive their salaries out of the 
circus' gross receipts, the circus is protected by Article 7 
and its income is not subject to host-country tax. Whether the 
salaries of the circus performers are subject to host-country 
tax under this Article depends on whether they exceed the 
$20,000 threshold in paragraph 1.
    Since pursuant to Article 1 (General Scope) the Convention 
only applies to persons who are residents of one of the 
Contracting States, income of the star company would not be 
eligible for benefits of the Convention if the company is not a 
resident of one of the Contracting States.

Relationship to Other Articles

    This Article 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 the other 
Contracting State 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 this Article, 
subject, however, to the special foreign tax credit provisions 
of paragraph 4 of Article 22 (Relief From Double Taxation). In 
addition, 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 (i.e., non-
government service) pensions, social security benefits, and 
annuities.

Paragraph 1

    Paragraph 1 provides that distributions from pensions and 
other similar remuneration paid to a resident of a Contracting 
State in consideration of past employment are taxable only in 
the State of residence of the beneficiary. The term ``pensions 
and other similar remuneration'' includes both periodic and 
single sum payments.
    The phrase ``pensions and other similar remuneration'' is 
intended to encompass payments made by qualified private 
retirement plans. In the United States, the plans encompassed 
by Paragraph 1 include: qualified plans under section 401(a), 
individual retirement plans (including individual 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 fall under Paragraph 1 if they are not paid with 
respect to government services covered by Article 19. In 
Iceland, the term pension 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 Convention. The 
competent authorities may agree that distributions from other 
plans that generally meet similar criteria to those applicable 
to the listed plans also qualify for the benefits of Paragraph 
1.
    Pensions in respect of government services covered by 
Article 18 are not covered by this paragraph. They 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 
(Government Service). Thus, Article 18 generally covers section 
457(g), 401(a), 403(a), and 403(b) plans established for 
government employees, including the Thrift Savings Plan 
(section 7701(j)).

Paragraph 2

    The treatment of social security benefits is dealt with in 
paragraph 2. This paragraph provides that, notwithstanding the 
provision of paragraph 1 under which private pensions are 
taxable exclusively in the State of residence of the beneficial 
owner, payments made by one of the Contracting States under the 
provisions of its social security or similar legislation to a 
resident of Iceland or to a citizen of the United States will 
be taxable only in the Contracting State making the payment. 
The reference to U.S. citizens is necessary to ensure that a 
social security payment by Iceland to a U.S. citizen who is not 
resident in the United States will not be taxable by the United 
States.
    This paragraph applies to social security beneficiaries 
whether they have contributed to the system as private sector 
or Government employees. The phrase ``similar legislation'' is 
intended to refer to United States tier 1 Railroad Retirement 
benefits.

Paragraph 3

    Under paragraph 3, annuities that are derived and 
beneficially owned by a resident of a Contracting State are 
taxable only in that State. An annuity, as the term is used in 
this paragraph, means a stated sum paid periodically at stated 
times during a specified number of years, under an obligation 
to make the payment in return for adequate and full 
consideration (other than for services rendered). An annuity 
received in consideration for services rendered would be 
treated as either deferred compensation that is taxable in 
accordance with Article 14 (Income from Employment) or a 
pension that is subject to the rules of paragraph 1.

Paragraph 4

    Paragraph 4 provides that, if a resident of a Contracting 
State participates in a pension fund established in the other 
Contracting State, the State of residence will not tax the 
income of the pension fund with respect to that resident until 
a distribution is made from the pension fund. Thus, 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, paragraph 1 prevents Iceland from taxing 
currently the plan's earnings and accretions with respect to 
that individual. When the resident receives a distribution from 
the pension fund, that distribution may be subject to tax in 
the State of residence, subject to paragraph 1.

Relationship to Other Articles

    Paragraphs 1 and 3 of Article 17 are subject to the saving 
clause of paragraph 4 of Article 1 (General Scope). Thus, a 
U.S. citizen who is resident in the other Contracting State, 
and receives either a pension, annuity or alimony payment from 
the United States, may be subject to U.S. tax on the payment, 
notwithstanding the rules in those three paragraphs that give 
the State of residence of the recipient the exclusive taxing 
right. Paragraphs 2 and 4 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)

Paragraph 1

    Subparagraphs 1(a) and 1(b) deal with the taxation of 
government compensation (other than a pension addressed in 
paragraph 2). Subparagraph 1(a) provides that remuneration paid 
from the public funds of a Contracting State or its political 
subdivisions or local authorities to any individual who is 
rendering services to that State, political subdivision or 
local authority,which are in the discharge of governmental 
functions, is exempt from tax by the other State. Under 
subparagraph 1(b), such payments are, however, taxable 
exclusively in the other State (i.e., the host State) if the 
services are rendered in that other State and the individual is 
a resident of that State who is either a national of that State 
or a person who did not become resident of that State solely 
for purposes of rendering the services. The paragraph applies 
to anyone performing services for a government, whether as a 
government employee, an independent contractor, or an employee 
of an independent contractor.

Paragraph 2

    Paragraph 2 deals with the taxation of pensions paid by, or 
out of funds created by, one of the States, or a political 
subdivision or a local authority thereof, to an individual in 
respect of services rendered in the discharge of functions of a 
governmental nature to that State or subdivision or authority. 
Subparagraph 1(a) provides that such pensions are taxable only 
in that State. Subparagraph 1(b) provides an exception under 
which such pensions are taxable only in the other State if the 
individual is a resident of, and a national of, that other 
State.
    Pensions paid to retired civilian and military employees of 
a Government of either State are intended to be covered under 
paragraph 2. When benefits paid by a State in respect of 
services rendered to that State or a subdivision or authority 
are in the form of social security benefits, however, those 
payments are covered by paragraph 2 of Article 17 (Pensions, 
Social Security, Annuities, Alimony, and Child Support). As a 
general matter, the result will be the same whether Article 17 
or 19 applies, since social security benefits are taxable 
exclusively by the source country and so are government 
pensions. The result will differ only when the payment is made 
to a citizen and resident of the other Contracting State, who 
is not also a citizen of the paying State. In such a case, 
social security benefits continue to be taxable at source while 
government pensions become taxable only in the residence 
country.

Paragraph 3

    Paragraph 3 provides that the remuneration described in 
paragraph 1 will be subject to the rules of Articles 14 (Income 
from Employment), 15 (Directors' Fees), 16 (Entertainers and 
Sportsmen) or 17 if the recipient of the income is employed by 
a business conducted by a government.

Relationship to Other Articles

    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 States under Article 18 if the 
recipient of the benefits is neither a citizen of that State, 
nor a person who has been admitted for permanent residence 
there (i.e., in the United States, a ``green card'' holder). 
Thus, a resident of a Contracting State who in the course of 
performing functions of a governmental nature becomes a 
resident of the other State (but not a permanent resident), 
would be entitled to the benefits of this Article. 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)

    This Article provides rules for host-country taxation of 
visiting students and business trainees. Persons who meet the 
tests of the Article will be exempt from tax in the State that 
they are visiting with respect to designated classes of income. 
Several conditions must be satisfied in order for an individual 
to be entitled to the benefits of this Article.

Paragraph 1

    Paragraph 1 provides that an individual who is a resident 
of one Contracting State at the time he becomes temporarily 
present in the other Contracting State and who is temporarily 
present therein for the primary purpose of studying at a 
university or other recognized educational institution in that 
other Contracting State, securing training required to qualify 
him to practice a profession or professional specialty, or 
studying or doing research as a recipient of a grant, 
allowance, or award from a governmental, religious, charitable, 
scientific, literary, or educational organization, will be 
exempt from tax by that other Contracting State for a period 
not exceeding five taxable years from the date of his arrival 
in that other Contracting State on:

          (1) Gifts from abroad for the purpose of his 
        maintenance, education, study, research or training;

          (2) The grant, allowance, or award; and

          (3) Income from personal services performed in the 
        other Contracting State not in excess of $9,000 or its 
        equivalent in Icelandic kronur for any taxable year.

Paragraph 2

    Under paragraph 2, an individual who is a resident of one 
Contracting State at the time he becomes temporarily present in 
the other Contracting State and who is temporarily present 
therein as an employee of, or under contract with, a resident 
of the first-mentioned Contracting State, for the primary 
purpose of acquiring technical, professional, or business 
experience from a person other than that resident of the first-
mentioned Contracting State or other than a person related to 
such resident, or studying at a university or other recognized 
educational institution in that other Contracting State, will 
be exempt from tax by that other Contracting State for a period 
of twelve consecutive months on income from personal services 
not in excess of $9,000 or its equivalent in Icelandic kronur.

Paragraph 3

    Paragraph 3 provides an exemption for residents of one 
Contracting State who become temporarily present in the other 
Contracting State for purposes of training, research or study 
in a program sponsored by the other Contracting State. The 
exemption is available to an individual who is a resident of 
one Contracting State at the time he becomes temporarily 
present in the other Contracting State and who is temporarily 
present in that other Contracting State for a period not 
exceeding one year, as a participant in a program sponsored by 
the other Contracting State, for the primary purpose of 
training, research, or study. A person meeting these 
requirements will be exempt from tax by the other Contracting 
State with respect to his income from personal services in 
respect of such training, research, or study performed in that 
other Contracting State in an aggregate amount not in excess of 
$9,000 or its equivalent in Icelandic kronur.

Relationship to Other Articles

    The saving clause of paragraph 4 of Article 1 (General 
Scope) does not apply to this Article with respect to an 
individual who is neither a citizen of the host State nor an 
individual who has been admitted for permanent residence there. 
The saving clause, however, does apply with respect to citizens 
and permanent residents of the host State. Thus, a U.S. citizen 
who is a resident of Iceland and who visits the United States 
as a full-time student at an accredited university will not be 
exempt from U.S. tax on remittances from abroad that otherwise 
constitute U.S. taxable income. An individual, however, who is 
not a U.S. citizen, and who visits the United States as a 
student and remains long enough to become a resident under U.S. 
law, but does not become a permanent resident (i.e., does not 
acquire a green card), will be entitled to the full benefits of 
the Article.

                       ARTICLE 20 (OTHER INCOME)

    Article 20 generally assigns taxing jurisdiction over 
income not dealt with in the other articles (Articles 6 (Income 
from Immovable Property (Real Property)) through 19 (Students 
and Trainees)) of the Convention to the State of residence of 
the beneficial owner of the income. 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 a Contracting State. For example, all 
royalty income that arises in a Contracting State and that is 
beneficially owned by a resident of the other Contracting State 
is ``dealt with'' in Article 12 (Royalties). 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 Contracting States.
    Examples of items of income covered by Article 20 include 
income from gambling, punitive (but not compensatory) damages 
and covenants not to compete. The article would also apply 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. For example, income from notional principal 
contracts and other derivatives would fall within Article 20 if 
derived by persons not engaged in the trade or business of 
dealing in such instruments, unless such instruments were being 
used to hedge risks arising in a trade or business. It would 
also apply to securities lending fees derived by an 
institutional investor. Further, in most cases guarantee fees 
paid within an intercompany group would be covered by Article 
20, unless the guarantor were engaged in the business of 
providing such guarantees to unrelated parties.
    Article 20 also applies to items of income that are not 
dealt with in the other articles because of their source or 
some other characteristic. For example, Article 11 (Interest) 
addresses only the taxation of interest arising in a 
Contracting State. Interest arising in a third State that is 
not attributable to a permanent establishment, therefore, is 
subject to 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 their distributive share of partnership 
income annually, 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 Convention. See  
Code section 641 et seq.

Paragraph 1

    The general rule of Article 20 is contained in paragraph 1. 
Items of income not dealt with in other articles and 
beneficially owned by a resident of a Contracting State will be 
taxable only in the State of residence. This exclusive right of 
taxation applies whether or not the residence State exercises 
its right to tax the income covered by the Article.
    The reference in this paragraph to ``items of income 
beneficially owned by a resident of a Contracting State'' 
rather than simply ``items of income of a resident of a 
Contracting State,'' as in the OECD Model, is intended merely 
to make explicit the implicit understanding in other treaties 
that the exclusive residence taxation provided by paragraph 1 
applies only when a resident of a Contracting State is the 
beneficial owner of the income. Thus, source taxation of income 
not dealt with in other articles of the Convention is not 
limited by paragraph 1 if it is nominally paid to a resident of 
the other Contracting State, but is beneficially owned by a 
resident of a third State. However, income received by a 
nominee on behalf of a resident of that other State would be 
entitled to benefits.
    The term ``beneficially owned'' is not defined in the 
Convention, and is, therefore, defined as under the internal 
law of the country imposing tax (i.e., the source country). The 
person who beneficially owns the income for purposes of Article 
20 is the person to which the income is attributable for tax 
purposes under the laws of the source State.

Paragraph 2

    This paragraph provides an exception to the general rule of 
paragraph 1 for income that is attributable to a permanent 
establishment maintained in a Contracting State by a resident 
of the other Contracting State. The taxation of such income is 
governed by the provisions of Article 7 (Business Profits). 
Therefore, income arising outside the United States that is 
paid in respect of a right or property that is effectively 
connected with a permanent establishment maintained in the 
United States by a resident of Iceland generally would be 
taxable by the United States under the provisions of Article 7. 
This would be true even if the income is sourced in a third 
state.

Relationship to Other Articles

    This Article is subject to the saving clause of paragraph 4 
of Article 1 (General Scope). Thus, the United States may tax 
the income of a resident of Iceland that is not dealt with 
elsewhere in the Convention, if that resident is a citizen of 
the United States. The 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)

    Article 21 contains anti-treaty-shopping provisions that 
are intended to prevent residents of third countries from 
benefiting from what is intended to be a reciprocal agreement 
between two countries. In general, the provision does not rely 
on a determination of purpose or intention but instead sets 
forth a series of objective tests. A resident of a Contracting 
State that satisfies one of the tests will receive benefits 
regardless of its motivations in choosing its particular 
business structure.
    The structure of the Article is as follows: Paragraph 1 
states the general rule that residents are entitled to benefits 
otherwise accorded to residents only to the extent provided in 
the Article. Paragraph 2 lists a series of attributes of a 
resident of a Contracting State, the presence of any one of 
which will entitle that person to all the benefits of the 
Convention. Paragraph 3 provides a so-called ``derivative 
benefits'' test under which certain categories of income may 
qualify for benefits. Paragraph 4 provides that, regardless of 
whether a person qualifies for benefits under paragraph 2, 
benefits may be granted to that person with regard to certain 
income earned in the conduct of an active trade or business. 
Paragraph 5 provides special rules for so-called ``triangular 
cases'' notwithstanding the other provisions of Article 21. 
Paragraph 6 provides special rules for income from so-called 
``disproportionate shares'' notwithstanding the other 
provisions of Article 21. Paragraph 7 provides that benefits 
also may be granted if the competent authority of the State 
from which benefits are claimed determines that it is 
appropriate to provide benefits in that case. Paragraph 8 
defines certain terms used in the Article.

Paragraph 1

    Paragraph 1 provides that a resident of a Contracting State 
will be entitled to the benefits otherwise accorded to 
residents of a Contracting State under the Convention only to 
the extent provided in the Article. The benefits otherwise 
accorded to residents under the Convention include all 
limitations on source-based taxation under Articles 6 (Income 
from Immovable Property (Real Property) through 20 (Other 
Income), the treaty-based relief from double taxation provided 
by Article 22 (Relief from Double Taxation), and the protection 
afforded to residents of a Contracting State under Article 23 
(Non-Discrimination). Some provisions do not require that a 
person be a resident in order to enjoy the benefits of those 
provisions. Article 24 (Mutual Agreement Procedure) is not 
limited to residents of the Contracting States, and Article 26 
(Members of Diplomatic Missions and Consular Posts) applies to 
diplomatic agents or consular officials regardless of 
residence. Article 21 accordingly does not limit the 
availability of treaty benefits under these provisions.
    Article 21 and the anti-abuse provisions of domestic law 
complement each other, as Article 21 effectively determines 
whether an entity has a sufficient nexus to the Contracting 
State to be treated as a resident for treaty purposes, while 
domestic anti-abuse provisions (e.g., business purpose, 
substance-over-form, step transaction or conduit principles) 
determine whether a particular transaction should be recast in 
accordance with its substance. Thus, internal law principles of 
the source Contracting State may be applied to identify the 
beneficial owner of an item of income, and Article 21 then will 
be applied to the beneficial owner to determine if that person 
is entitled to the benefits of the Convention with respect to 
such income.

Paragraph 2

    Paragraph 2 has five subparagraphs, each of which describes 
a category of residents that are entitled to all benefits of 
the Convention.
    It is intended that the provisions of paragraph 2 will be 
self executing. Unlike the provisions of paragraph 7, discussed 
below, claiming benefits under paragraph 2 does not require 
advance competent authority ruling or approval. The tax 
authorities may, of course, on review, determine that the 
taxpayer has improperly interpreted the paragraph and is not 
entitled to the benefits claimed.
            Individuals--Subparagraph 2(a)
    Subparagraph 2(a) provides that individual residents of a 
Contracting State will be entitled to all treaty benefits. If 
such an individual receives income as a nominee on behalf of a 
third country resident, benefits may be denied under the 
respective articles of the Convention by the requirement that 
the beneficial owner of the income be a resident of a 
Contracting State.
            Governments--Subparagraph 2(b)
    Subparagraph 2(b) provides that the Contracting States and 
any political subdivision or local authority thereof will be 
entitled to all benefits of the Convention.
            Publicly-Traded Corporations--Subparagraph 2(c)(i)
    Subparagraph 2(c) applies to two categories of companies: 
publicly traded companies and subsidiaries of publicly traded 
companies. A company resident in a Contracting State is 
entitled to all the benefits of the Convention under clause (i) 
of subparagraph 2(c) if the principal class of its shares is 
regularly traded on one or more recognized stock exchanges and 
the company satisfies at least one of the following additional 
requirements: first, the company's principal class of shares is 
primarily traded on one or more recognized stock exchanges 
located in the Contracting State of which the company is a 
resident; or, second, the company's primary place of management 
and control is in its State of residence.
    The term ``recognized stock exchange'' is defined in 
subparagraph 8(b). It includes (i) the NASDAQ System and any 
stock exchange registered with the Securities and Exchange 
Commission as a national securities exchange for purposes of 
the Securities Exchange Act of 1934; (ii) the Icelandic Stock 
Exchange; (iii) the stock exchanges of Amsterdam, Brussels, 
Copenhagen, Frankfurt, Hamburg, Helsinki, London, Oslo, Paris, 
Stockholm, Sydney, Tokyo, and Toronto; and (iv) any other stock 
exchange agreed upon by the competent authorities of the 
Contracting States.
    If a company has only one class of shares, it is only 
necessary to consider whether the shares of that class meet the 
relevant trading requirements. If the company has more than one 
class of shares, it is necessary as an initial matter to 
determine which class or classes constitute the ``principal 
class of shares''. The term ``principal class of shares'' is 
defined in subparagraph 8(a) to mean the ordinary or common 
shares of the company representing the majority of the 
aggregate voting power and value of the company. If the company 
does not have a class of ordinary or common shares representing 
the majority of the aggregate voting power and value of the 
company, then the ``principal class of shares'' is that class 
or any combination of classes of shares that represents, in the 
aggregate, a majority of the voting power and value of the 
company. Although in a particular case involving a company with 
several classes of shares it is conceivable that more than one 
group of classes could be identified that account for more than 
50% of the shares, it is only necessary for one such group to 
satisfy the requirements of this subparagraph in order for the 
company to be entitled to benefits. Benefits would not be 
denied to the company even if a second, non-qualifying, group 
of shares with more than half of the company's voting power and 
value could be identified.
    The term ``regularly traded'' is not defined in the 
Convention. In accordance with paragraph 2 of Article 3 
(General Definitions), this term will be defined by reference 
to the domestic tax laws of the State from which treaty 
benefits are sought, generally the source State. In the case of 
the United States, this term is understood to have the meaning 
it has under Treas. Reg. section 1. 884-5(d)(4)(i)(B), relating 
to the branch tax provisions of the Code. Under these 
regulations, a class of shares is considered to be ``regularly 
traded'' if two requirements are met: trades in the class of 
shares are made in more than de minimis quantities on at least 
60 days during the taxable year, and 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. Sections 1.884-5(d)(4)(i)(A), (ii) and (iii) will not be 
taken into account for purposes of defining the term 
``regularly traded'' under the Convention.
    The regular trading requirement can be met by trading on 
any recognized exchange or exchanges located in either State. 
Trading on one or more recognized stock exchanges may be 
aggregated for purposes of this requirement. Thus, a U.S. 
company could satisfy the regularly traded requirement through 
trading, in whole or in part, on a recognized stock exchange 
located in Iceland. Authorized but unissued shares are not 
considered for purposes of this test.
    The term ``primarily traded'' is not defined in the 
Convention. In accordance with paragraph 2 of Article 3, this 
term will have the meaning it has under the laws of the State 
concerning the taxes to which the Convention applies, generally 
the source State. In the case of the United States, this term 
is understood to have the meaning it has under Treas. Reg. 
section 1.884-5(d)(3), relating to the branch tax provisions of 
the Code. Accordingly, stock of a corporation is ``primarily 
traded'' 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 Contracting State 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 whose principal class of shares is regularly 
traded on a recognized exchange but cannot meet the primarily 
traded test may claim treaty benefits if its primary place of 
management and control is in its country of residence. This 
test should be distinguished from the ``place of effective 
management'' test which is used in the OECD Model and by many 
other countries to establish residence. In some cases, the 
place of effective management test has been interpreted to mean 
the place where the board of directors meets. By contrast, the 
primary place of management and control test looks to where 
day-to-day responsibility for the management of the company 
(and its subsidiaries) is exercised. The company's primary 
place of management and control will be located in the State 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 State than in the 
other State or any third state, and the staff that support the 
management in making those decisions are also based in that 
State. Thus, the test looks to the overall activities of the 
relevant persons to see where those activities are conducted. 
In most cases, it will be a necessary, but not a sufficient, 
condition that the headquarters of the company (that is, the 
place at which the Chief Executive Officer and other top 
executives normally are based) be located in the Contracting 
State of which the company is a resident.
    To apply the test, it will be necessary to determine which 
persons are to be considered ``executive officers and senior 
management employees''. In most cases, it will not be necessary 
to look beyond the executives who are members of the Board of 
Directors (the ``inside directors'') in the case of a U.S. 
company. That will not always be the case, however; in fact, 
the relevant persons may be employees of subsidiaries if those 
persons make the strategic, financial and operational policy 
decisions. Moreover, it would be necessary to take into account 
any special voting arrangements that result in certain board 
members making certain decisions without the participation of 
other board members.
            Subsidiaries of Publicly-Traded Corporations--Subparagraph 
                    2(c)(ii)
    A company resident in a Contracting State is entitled to 
all the benefits of the Convention under clause (ii) of 
subparagraph 2(c) if five or fewer publicly traded companies 
described in clause (i) are the direct or indirect owners of at 
least 50 percent of the aggregate vote and value of the 
company's shares. If the publicly-traded companies are indirect 
owners, however, each of the intermediate companies must be a 
resident of one of the Contracting States.
    Thus, for example, a company that is a resident of Iceland, 
all the shares of which are owned by another company that is a 
resident of Iceland, would qualify for benefits under the 
Convention if the principal class of shares of the parent 
company are regularly and primarily traded on a recognized 
stock exchange in Iceland. However, such a subsidiary would not 
qualify for benefits under clause (ii) if the publicly traded 
parent company were a resident of a third state, for example, 
and not a resident of the United States or Iceland. 
Furthermore, if a parent company in Iceland indirectly owned 
the bottom-tier company through a chain of subsidiaries, each 
such subsidiary in the chain, as an intermediate owner, must be 
a resident of the United States or Iceland in order for the 
subsidiary to meet the test in clause (ii).
            Tax Exempt Organizations--Subparagraph 2(d)
    Subparagraph 2(d) provides rules by which the tax exempt 
organizations described in paragraph 2 of Article 4 (Resident) 
will be entitled to all the benefits of the Convention. A 
pension scheme described in paragraph 2(a) of Article 4 or an 
employee benefits plan described in paragraph 2(b) of Article 4 
will qualify for benefits if more than fifty percent of the 
beneficiaries, members or participants of the organization are 
individuals resident in either Contracting State. For purposes 
of this provision, the term ``beneficiaries'' should be 
understood to refer to the persons receiving benefits from the 
organization. On the other hand, an organization resident in a 
Contracting State that is established exclusively for 
religious, charitable, scientific, artistic, cultural, or 
educational purposes automatically qualifies for benefits, 
without regard to the residence of its beneficiaries or 
members.
            Ownership/Base Erosion--Subparagraph 2(e)
    Subparagraph 2(e) provides an additional method to qualify 
for treaty benefits that applies to any form of legal entity 
that is a resident of a Contracting State. The test provided in 
subparagraph 2(e), the so-called ownership and base erosion 
test, is a two-part test. Both prongs of the test must be 
satisfied for the resident to be entitled to treaty benefits 
under subparagraph 2(e).
    The ownership prong of the test, under clause (i), requires 
that 50 percent or more of each class of shares or other 
beneficial interests in the person is owned, directly or 
indirectly, on at least half the days of the person's taxable 
year by persons who are residents of the Contracting State of 
which that person is a resident and that are themselves 
entitled to treaty benefits under subparagraphs 2(a), 2(b), 
2(d) or clause (i) of subparagraph 2(c). In the case of 
indirect owners, however, each of the intermediate owners must 
be a resident of that Contracting State.
    Trusts may be entitled to benefits under this provision if 
they are treated as residents under Article 4 and they 
otherwise satisfy the requirements of this subparagraph. For 
purposes of this subparagraph, the beneficial interests in a 
trust will be considered to be owned by its beneficiaries in 
proportion to each beneficiary's actuarial interest in the 
trust. The interest of a remainder beneficiary will be equal to 
100 percent less the aggregate percentages held by income 
beneficiaries. A beneficiary's interest in a trust will not be 
considered to be owned by a person entitled to benefits under 
subparagraphs 2(a), 2(b), 2(d) or clause (i) of subparagraph 
2(c) if it is not possible to determine the beneficiary's 
actuarial interest. Consequently, if it is not possible to 
determine the actuarial interest of the beneficiaries in a 
trust, the ownership test under clause i) cannot be satisfied, 
unless all possible beneficiaries are persons entitled to 
benefits under subparagraphs 2(a), 2(b), 2(d) or clause (i) of 
subparagraph 2(c) .
    The base erosion prong of clause (ii) of subparagraph 2(e) 
is satisfied with respect to a person if less than 50 percent 
of the person's gross income for the taxable year, as 
determined under the tax law in the person's State of 
residence, is paid or accrued, directly or indirectly, to 
persons who are not residents of either Contracting State 
entitled to benefits under subparagraphs 2(a), 2(b), 2(d) or 
clause (i) of subparagraph 2(c), in the form of payments 
deductible for tax purposes in the payer's State of residence. 
These amounts do not include arm's-length payments in the 
ordinary course of business for services or tangible property, 
or payments in respect of financial obligations to a bank, 
provided that where such a bank is not a resident of a 
Contracting State, such payment is attributable to a permanent 
establishment of that bank located in one of the Contracting 
States. To the extent they are deductible from the taxable 
base, trust distributions are deductible payments. However, 
depreciation and amortization deductions, which do not 
represent payments or accruals to other persons, are 
disregarded for this purpose.

Paragraph 3

    Paragraph 3 sets forth a derivative benefits test that is 
potentially applicable to all treaty benefits, although the 
test is applied to individual items of income. In general, a 
derivative benefits test entitles the resident of a Contracting 
State to treaty benefits if the owner of the resident would 
have been entitled to the same benefit had the income in 
question flowed directly to that owner. To qualify under this 
paragraph, the company must meet an ownership test and a base 
erosion test.
    Clause (i) of subparagraph 3(a) sets forth the ownership 
test. Under this test, at least 95 percent of the aggregate 
voting power and value of the shares of the company must be 
owned by seven or fewer persons that are residents of Member 
States of the European Union, or of the European Economic Area, 
or parties to the North American Free Trade Agreement or the 
European Free Trade Agreement. Ownership may be direct or 
indirect. To be considered a resident of Member States of the 
European Union, or of the European Economic Area, or parties to 
the North American Free Trade Agreement or the European Free 
Trade Agreement for purposes of paragraph 3, a person must meet 
the requirements of subparagraph 3(b). These requirements may 
be met in two alternative ways.
    Under one alternative, a person may be treated as a 
resident of Member States of the European Union, or of the 
European Economic Area, or parties to the North American Free 
Trade Agreement or the European Free Trade Agreement because it 
is entitled to equivalent benefits under a treaty between the 
country of source and the country in which the person is a 
resident. To satisfy this requirement, the person must be 
entitled to all the benefits of a comprehensive income tax 
convention in force between the Contracting State from which 
benefits of the Convention are claimed and a qualifying state 
under provisions that are analogous to the rules in 
subparagraphs 2(a), 2(b), 2(d) and clause (i) of subparagraph 
2(c). If the treaty in question does not have a comprehensive 
limitation on benefits article, this requirement is met only if 
the person would be entitled to treaty benefits under the tests 
in subparagraphs 2(a), 2(b), 2(d) and clause (i) of 
subparagraph 2(c) of this Article if the person were a resident 
of one of the Contracting States.
    In order to satisfy this alternative with respect to 
dividends, interest, royalties or branch tax, the person must 
be entitled to a rate of tax that is at least as low as the tax 
rate that would apply under the Convention to such income. 
Thus, the rates to be compared are: (1) the rate of tax that 
the source State would have imposed if a qualified resident of 
the other Contracting State was the beneficial owner of the 
income; and (2) the rate of tax that the source State would 
have imposed if the third State resident received the income 
directly from the source State. For example, USCo is a wholly 
owned subsidiary of IceCo, a company resident in Iceland. IceCo 
is wholly owned by CanCo, a corporation resident in Canada. 
Assuming IceCo satisfies the requirements of paragraph 2 of 
Article 10 (Dividends), IceCo would be eligible for a dividend 
withholding tax rate of 5 percent. The dividend withholding tax 
rate in the treaty between the United States and Canada is also 
5 percent. Thus, if CanCo received the dividend directly from 
USCo, CanCo would have been subject to a 5 percent rate of 
withholding tax on the dividend. Because CanCo would be 
entitled to a rate of withholding tax that is at least as low 
as the rate that would apply under the Convention to such 
income, CanCo is treated as a resident of Member States of the 
European Union, or of the European Economic Area, or parties to 
the North American Free Trade Agreement or the European Free 
Trade Agreement with respect to the elimination of withholding 
tax on dividends.
    The requirement that a person be entitled to ``all the 
benefits'' of a comprehensive tax treaty eliminates those 
persons that qualify for benefits with respect to only certain 
types of income. Accordingly, the fact that a Canadian parent 
of an Icelandic company is engaged in the active conduct of a 
trade or business in Canada and therefore would be entitled to 
the benefits of the U. S.-Canada treaty if it received 
dividends directly from a U.S. subsidiary of the Icelandic 
company is not sufficient for purposes of this paragraph. 
Further, the Canadian company cannot be an equivalent 
beneficiary if it qualifies for benefits only with respect to 
certain income as a result of a ``derivative benefits'' 
provision in the U.S.-Canada treaty.
    However, it would be possible to look through the Canadian 
company to its parent company to determine whether the parent 
company is an equivalent beneficiary.
    The second alternative requirement for treatment as a 
resident of Member States of the European Union, or of the 
European Economic Area, or parties to the North American Free 
Trade Agreement or the European Free Trade Agreement is 
available only to residents of one of the two Contracting 
States. U.S. or Icelandic residents who are eligible for treaty 
benefits by reason of subparagraphs 2(a), 2(b), 2(d) or clause 
(i) of subparagraph 2(c) are treated as residents of Member 
States of the European Union, or of the European Economic Area, 
or parties to the North American Free Trade Agreement or the 
European Free Trade Agreement under the second alternative. 
Thus, an Icelandic individual will qualify without regard to 
whether the individual would have been entitled to receive the 
same benefits if it received the income directly. A resident of 
a third country cannot qualify for treaty benefits under any of 
those subparagraphs or any other rule of the treaty, and 
therefore does not qualify under this alternative. Thus, a 
resident of a third country will be treated as a resident of 
Member States of the European Union, or of the European 
Economic Area, or parties to the North American Free Trade 
Agreement or the European Free Trade Agreement only if it would 
have been entitled to equivalent benefits had it received the 
income directly.
    The second alternative was included in order to clarify 
that ownership by certain residents of a Contracting State 
would not disqualify a U.S. or Icelandic company under this 
paragraph. Thus, for example, if 90 percent of an Icelandic 
company is owned by five companies that are resident in member 
states of the European Union who satisfy the requirements of 
clause (ii), and 10 percent of the Icelandic company is owned 
by a U.S. or Icelandic individual, then the Icelandic company 
still can satisfy the requirements of subparagraph 3(b).
    Clause (ii) of subparagraph 3(a) sets forth the base 
erosion test. A company meets this base erosion test if less 
than 50 percent of its gross income (as determined in the 
company's State of residence) for the taxable period is paid or 
accrued, directly or indirectly, to a person or persons who are 
not residents of Member States of the European Union, or of the 
European Economic Area, or parties to the North American Free 
Trade Agreement or the European Free Trade Agreement in the 
form of payments deductible for tax purposes in company's State 
of residence.

Paragraph 4

    Paragraph 4 sets forth an alternative test under which a 
resident of a Contracting State may receive treaty benefits 
with respect to certain items of income that are connected to 
an active trade or business conducted in its State of 
residence. A resident of a Contracting State may qualify for 
benefits under paragraph 4 whether or not it also qualifies 
under paragraph 2 or 3.
    Subparagraph 4(a) sets forth the general rule that a 
resident of a Contracting State engaged in the active conduct 
of a trade or business in that State may obtain the benefits of 
the Convention with respect to an item of income derived in the 
other Contracting State. The item of income, however, must be 
derived in connection with or incidental to that trade or 
business.
    The term ``trade or business'' is not defined in the 
Convention. Pursuant to paragraph 2 of Article 3 (General 
Definitions), when determining whether a resident of Iceland is 
entitled to the benefits of the Convention under paragraph 3 of 
this Article 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 law of 
the United States. Accordingly, the U.S. competent authority 
will refer to the regulations issued under section 3 67(a) for 
the definition of the term ``trade or business.'' In general, 
therefore, 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 business of making or managing investments for the 
resident's own account will be considered to be a trade or 
business only when part of banking, insurance or securities 
activities conducted by a bank, an insurance company, or a 
registered securities dealer. Such activities conducted by a 
person other than a bank, insurance company or registered 
securities dealer will not be considered to be the conduct of 
an active trade or business, nor would they be considered to be 
the conduct of an active trade or business if conducted by a 
bank, insurance company or registered securities dealer but not 
as part of the company's banking, insurance or dealer business. 
Because a headquarters operation is in the business of managing 
investments, a company that functions solely as a headquarters 
company will not be considered to be engaged in an active trade 
or business for purposes of paragraph 3.
    An item of income is derived in connection with a trade or 
business if the income-producing activity in the State of 
source is a line of business that ``forms a part of'' or is 
``complementary'' to the trade or business conducted in the 
State of residence by the income recipient.
    A business activity generally will be considered to form 
part of a business activity conducted in the State of source if 
the two activities involve 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 State of 
residence may be upstream, downstream, or parallel to the 
activity conducted in the State of source. Thus, the line of 
business may provide inputs for a manufacturing process that 
occurs in the State of source, 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 State of source.

    Example 1. USCo is a corporation resident in the United 
States. USCo is engaged in an active manufacturing business in 
the United States. USCo owns 100 percent of the shares of ICo, 
a corporation resident in Iceland. ICo distributes USCo 
products in Iceland. Since the business activities conducted by 
the two corporations involve the same products, ICo's 
distribution business is considered to form a part of USCo's 
manufacturing business.

    Example 2. The facts are the same as in Example 1, except 
that USCo does not manufacture. Rather, USCo operates a large 
research and development facility in the United States that 
licenses intellectual property to affiliates worldwide, 
including ICo. ICo and other USCo affiliates then manufacture 
and market the USCo-designed products in their respective 
markets. Since the activities conducted by ICo and USCo involve 
the same product lines, these activities are considered to form 
a part of the same trade or business.
    For two activities to be considered to be 
``complementary,'' the activities need not relate to the same 
types of products or services, but they should be part of the 
same overall industry and 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 State 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 State of residence, it is 
necessary to identify the trade or business to which an item of 
income is attributable. Royalties generally will be considered 
to be derived in connection with the trade or business to which 
the underlying intangible property is attributable. Dividends 
will be 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.

    Example 3. Americair is a corporation resident in the 
United States that operates an international airline. IceSub is 
a wholly-owned subsidiary of Americair resident in Iceland. 
IceSub operates a chain of hotels in Iceland that are located 
near airports served by Americair flights. Americair frequently 
sells tour packages that include air travel to Iceland and 
lodging at Ice Sub hotels. Although both companies are engaged 
in the active conduct of a trade or business, the businesses of 
operating a chain of hotels and operating an airline are 
distinct trades or businesses. Therefore IceSub's business does 
not form a part of Americair's business. However, IceSub's 
business is considered to be complementary to Americair's 
business because they are part of the same overall industry 
(travel) and the links between their operations tend to make 
them interdependent.

    Example 4. The facts are the same as in Example 3, except 
that IceSub owns an office building in Iceland instead of a 
hotel chain. No part of Americair's business is conducted 
through the office building. IceSub's business is not 
considered to form a part of or to be complementary to 
Americair's business. They are engaged in distinct trades or 
businesses in separate industries, and there is no economic 
dependence between the two operations.

    Example 5. USFlower is a corporation resident in the United 
States. USFlower produces and sells flowers in the United 
States and other countries. USFlower owns all the shares of 
IceHolding, a corporation resident in Iceland. IceHolding is a 
holding company that is not engaged in a trade or business. 
IceHolding owns all the shares of three corporations that are 
resident in Iceland: IceFlower, IceLawn, and IceFish. IceFlower 
distributes USFlower flowers under the USFlower trademark in 
Iceland. IceLawn markets a line of lawn care products in 
Iceland under the USFlower trademark. In addition to being sold 
under the same trademark, IceLawn and IceFlower products are 
sold in the same stores and sales of each company's products 
tend to generate increased sales of the other's products. 
IceFish imports fish from the United States and distributes it 
to fish wholesalers in Iceland. For purposes of paragraph 3, 
the business of IceFlower forms a part of the business of 
USFlower, the business of IceLawn is complementary to the 
business of USFlower, and the business of IceFish is neither 
part of nor complementary to that of USFlower.
    An item of income derived from the State of source is 
``incidental to'' the trade or business carried on in the State 
of residence if production of the item facilitates the conduct 
of the trade or business in the State of residence. An example 
of incidental income is the temporary investment of working 
capital of a person in the State of residence in securities 
issued by persons in the State of source.
    Subparagraph 4(b) states a further condition to the general 
rule in subparagraph 4(a) in cases where the trade or business 
generating the item of income in question is carried on either 
by the person deriving the income or by any associated 
enterprises. Subparagraph 4(b) states that the trade or 
business carried on in the State of residence, under these 
circumstances, must be substantial in relation to the activity 
in the State of source. 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 (i.e., 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 
Contracting State the nature of the activities performed in 
each Contracting State, and the relative contributions made to 
that trade or business in each Contracting State.
    The determination in subparagraph 4(b) also is made 
separately for each item of income derived from the State of 
source. It therefore is possible that a person would be 
entitled to the benefits of the Convention with respect to one 
item of income but not with respect to another. If a resident 
of a Contracting State is entitled to treaty benefits with 
respect to a particular item of income under paragraph 3, the 
resident is entitled to all benefits of the Convention insofar 
as they affect the taxation of that item of income in the State 
of source.
    Subparagraph 4(c) provides special attribution rules for 
purposes of applying the substantive rules of subparagraph 
4(a). Thus, these rules apply for purposes of determining 
whether a person meets the requirement in subparagraph 4(a) 
that it be engaged in the active conduct of a trade or business 
and that the item of income is derived in connection with that 
active trade or business. Subparagraph 4(c) attributes to a 
person activities conducted by a partnership in which that 
person is a partner and activities conducted by persons 
``connected'' to such person. A person (``X'') is connected to 
another person (``Y'') if X possesses 50 percent or more of the 
beneficial interest in Y (or if Y possesses 50 percent or more 
of the beneficial interest in X). For this purpose, X is 
connected to a company if X owns shares representing fifty 
percent or more of the aggregate voting power and value of the 
company or fifty percent or more of the beneficial equity 
interest in the company. X also is connected to Y if a third 
person possesses, directly or indirectly, fifty percent or more 
of the beneficial interest in both X and Y. For this purpose, 
if X or Y is a company, the threshold relationship with respect 
to such company or companies is fifty percent or more of the 
aggregate voting power and value or fifty percent or more of 
the beneficial equity interest. Finally, X is connected to Y 
if, based upon all the facts and circumstances, X controls Y, Y 
controls X, or X and Y are controlled by the same person or 
persons.

Paragraph 5

    Paragraph 5 deals with the treatment of income in the 
context of a so-called ``triangular case.''
    The term ``triangular case'' refers to the use of the 
following structure by a resident of Iceland to earn, in this 
case, interest income from the United States. The resident of 
Iceland, who is assumed to qualify for benefits under one or 
more of the provisions of Article 16 (Limitation on Benefits), 
sets up a permanent establishment in a third jurisdiction that 
imposes only a low rate of tax on the income of the permanent 
establishment. The Icelandic resident lends funds into the 
United States through the permanent establishment. The 
permanent establishment, despite its third-jurisdiction 
location, is an integral part of a Icelandic resident. 
Therefore the income that it earns on those loans, absent the 
provisions of paragraph 5, is entitled to exemption from U.S. 
withholding tax under the Convention. Under a current Icelandic 
income tax treaty with the host jurisdiction of the permanent 
establishment, the income of the permanent establishment is 
exempt from Icelandic tax (alternatively, Iceland may choose to 
exempt the income of the permanent establishment from Icelandic 
income tax). Thus, the interest income is exempt from U.S. tax, 
is subject to little tax in the host jurisdiction of the 
permanent establishment, and is exempt from Icelandic tax.
    Paragraph 5 applies reciprocally. However, the United 
States does not exempt the profits of a third-jurisdiction 
permanent establishment of a U.S. resident from U.S. tax, 
either by statute or by treaty.
    Paragraph 5 provides that the tax benefits that would 
otherwise apply under the Convention will not apply to any item 
of income if the combined tax actually paid in the residence 
State and the third state is less than 60 percent of the tax 
that would have been payable in the residence State if the 
income were earned in that State by the enterprise and were not 
attributable to the permanent establishment in the third state. 
In the case of dividends, interest and royalties to which this 
paragraph applies, the withholding tax rates under the 
Convention are replaced with a 15 percent withholding tax. Any 
other income to which the provisions of paragraph 5 apply is 
subject to tax under the domestic law of the source State, 
notwithstanding any other provisions of the Convention.
    In general, the principles employed under Code section 
954(b) (4) will be employed to determine whether the profits 
are subject to an effective rate of taxation that is above the 
specified threshold.
    Notwithstanding the level of tax on interest and royalty 
income of the permanent establishment, paragraph 5 will not 
apply under certain circumstances. In the case of royalties, 
paragraph 5 will not apply if the royalties 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, paragraph 5 will 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 state. 
The business of making, managing or simply holding investments 
is not considered to be an active trade or business, unless 
these are banking or securities activities carried on by a bank 
or registered securities dealer.

Paragraph 6

    Paragraph 6 provides a special rule where a company 
resident in a Contracting State, or a company that controls 
such a company directly or indirectly, has a class of shares 
that is subject to terms or other arrangements that entitle the 
holder to a larger portion of the company's income than the 
portion the holders would receive absent such terms or 
arrangements (``the disproportionate part of the income''). 
Where 50 percent or more of such a class of shares is owned by 
persons who are not entitled to benefits under paragraph 2, the 
benefits of the Convention shall not apply with respect to the 
disproportionate part of the income of the Company.

    The following example illustrates this result.

    Example. IceCo is a corporation resident in Iceland. IceCo 
has two classes of shares: Common and Preferred. The Common 
shares are listed and regularly traded on the Icelandic Stock 
Exchange. The Preferred shares have no voting rights and are 
entitled to receive dividends equal in amount to interest 
payments that IceCo receives from unrelated borrowers in the 
United States. The Preferred shares are owned entirely by a 
single investor that is a resident of a third country. The 
Common shares account for more than 50 percent of the value of 
IceCo and for 100 percent of the voting power. Because the 
owner of the Preferred shares is entitled to receive payments 
corresponding to the U.S. source interest income earned by 
IceCo, the Preferred shares are a disproportionate class of 
shares. Because the Preferred shares are not owned by persons 
entitled to benefits under paragraph 2, the benefits of the 
Convention shall not apply with respect to IceCo's U.S.-source 
interest income.

Paragraph 7

    Paragraph 7 provides that a resident of one of the States 
that is not entitled to the benefits of the Convention as a 
result of paragraphs 1 through 5 still shall be granted 
benefits under the Convention if the competent authority of the 
State from which benefits are claimed determines that the 
establishment, acquisition, or maintenance of the person 
seeking benefits under the Convention, or the conduct of such 
person's operations, has or had as one of its principal 
purposes the obtaining of benefits under the Convention. 
Benefits will not be granted, however, solely because a company 
was established prior to the effective date of a treaty or 
protocol. In that case a company would still be required to 
establish, to the satisfaction of the competent authority, 
clear non-tax business reasons for its formation in a 
Contracting State, or that the allowance of benefits would not 
otherwise be contrary to the purposes of the treaty. Thus, 
persons that establish operations in one of the States with a 
principal purpose of obtaining the benefits of the Convention 
ordinarily will not be granted relief under paragraph 7.
    The competent authority's discretion is quite broad. It may 
grant all of the benefits of the Convention to the taxpayer 
making the request, or it may grant only certain benefits. For 
instance, it may grant benefits only with respect to a 
particular item of income in a manner similar to paragraph 3. 
Further, the competent authority may establish conditions, such 
as setting time limits on the duration of any relief granted.
    For purposes of implementing paragraph 7, a taxpayer will 
be permitted to present his case to the relevant competent 
authority for an advance determination based on the facts. In 
these circumstances, it is also expected that, if the competent 
authority determines that benefits are to be allowed, they will 
be allowed retroactively to the time of entry into force of the 
relevant treaty provision or the establishment of the structure 
in question, whichever is later.
    Finally, there may be cases in which a resident of a 
Contracting State may apply for discretionary relief to the 
competent authority of his State of residence. This would 
arise, for example, if the benefit it is claiming is provided 
by the residence country, and not by the source country. So, 
for example, if a company that is a resident of the United 
States would like to claim the benefit of the re-sourcing rule 
of subparagraph 2(a) of Article 22, but it does not meet any of 
the objective tests of paragraphs 2 through 5, it may apply to 
the U.S. competent authority for discretionary relief.

Paragraph 8

    Paragraph 8 defines several key terms for purposes of 
Article 22. Each of the defined terms is discussed above in the 
context in which it is used.

                ARTICLE 22 (RELIEF FROM DOUBLE TAXATION)

    This Article describes the manner in which each Contracting 
State undertakes to relieve double taxation. The United States 
uses the foreign tax credit method under its internal law, and 
by treaty.

Paragraph 1

    The United States agrees, in paragraph 1, to allow to its 
citizens and residents a credit against U.S. tax for income 
taxes paid or accrued to Iceland. Paragraph 1 also provides 
that Iceland's covered taxes are income taxes for U.S. 
purposes. This provision is based on the Treasury Department's 
review of Iceland's laws.
    Subparagraph 1(b) provides for a deemed-paid credit, 
consistent with section 902 of the Code, to a U.S. corporation 
in respect of dividends received from a corporation resident in 
Iceland of which the U.S. corporation owns at least 10 percent 
of the voting stock. This credit is for the tax paid by the 
corporation to Iceland on the profits out of which the 
dividends are considered paid.
    The credits allowed under paragraph 1 are allowed in 
accordance with the provisions and subject to the limitations 
of U.S. law, as that law may be amended over time, so long as 
the general principle of the Article, that is, the allowance of 
a credit, is retained. Thus, although the Convention provides 
for a foreign tax credit, the terms of the credit are 
determined by the provisions, at the time a credit is given, of 
the U.S. statutory credit.
    Therefore, the U.S. credit under the Convention is subject 
to the various limitations of U.S. law (see, e.g., Code 
sections 901-908). For example, the credit against U.S. tax 
generally is limited to the amount of U.S. tax due with respect 
to net foreign source income within the relevant foreign tax 
credit limitation category (see Code section 904(a) and (d)), 
and the dollar amount of the credit is determined in accordance 
with U.S. currency translation rules (see, e.g., Code section 
986). Similarly, U.S. law applies to determine carryover 
periods for excess credits and other inter-year adjustments.

Paragraph 2

    Paragraph 2 provides a re-sourcing rule for gross income 
covered by paragraph 1. Subparagraph 2(a) is intended to ensure 
that a U.S. resident can obtain an appropriate amount of U.S. 
foreign tax credit for income taxes paid to Iceland when the 
Convention assigns to Iceland primary taxing rights over an 
item of gross income.
    Accordingly, if the Convention allows Iceland to tax an 
item of gross income (as defined under U.S. law) derived by a 
resident of the United States, the United States will treat 
that item of gross income as gross income from sources within 
Iceland for U.S. foreign tax credit purposes. In the case of a 
U.S.-owned foreign corporation, however, section 904(g)(10) may 
apply for purposes of determining the U.S. foreign tax credit 
with respect to income subject to this re-sourcing rule. 
Section 904(g)(10) generally applies the foreign tax credit 
limitation separately to re-sourced income. Furthermore, the 
subparagraph 2(a) re-sourcing rule applies to gross income, not 
net income. Accordingly, U.S. expense allocation and 
apportionment rules, see, e.g., Treas. Reg. section 1.861-9, 
continue to apply to income resourced under subparagraph 2(a).
    Subparagraph 2(b) provides that gains derived by an 
individual who was a resident of the United States that are 
taxed by the United States in accordance with the Convention, 
and that may also be taxed in Iceland solely by reason of 
Article 13 (Capital Gains) , shall be deemed to be gains from 
sources in the United States. 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.

Paragraph 3

    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 Convention, 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 credits 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 
Convention, may be taxed by the United States, Iceland shall 
allow the credit against Icelandic tax described in 
subparagraph 3(b). However, subparagraph 3(c) also permits 
Iceland to include the income corresponding to the U.S. tax in 
the resident's tax base for purposes of determining the 
Icelandic tax. This rule is a variation of the ``exemption with 
progression rule,'' adapted to accommodate Iceland's credit 
system. It is also 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 this Article, the U.S. taxes 
referred to in subparagraph 3(b) and paragraph 4 of Article 2 
(Taxes Covered) are considered to be income taxes and are 
allowed as credits against Icelandic tax on income, subject to 
all of the provisions and limitations of this paragraph.

Paragraph 4

    Paragraph 4 provides special rules for the tax treatment in 
both States of certain types of income derived from U.S. 
sources by U.S. citizens who are residents of Iceland. Since 
U.S. citizens, regardless of residence, are subject to United 
States tax at ordinary progressive rates on their worldwide 
income, the U.S. tax on the U.S. source income of a U.S. 
citizen resident in Iceland may exceed the U.S. tax that may be 
imposed under the Convention on an item of U.S. source income 
derived by a resident of Iceland who is not a U.S. citizen. 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, with respect to items of income 
from sources within the United States, special credit rules for 
Iceland. These rules apply to items of U. S.-source income that 
would be either exempt from U.S. tax or subject to reduced 
rates of U.S. tax under the provisions of the Convention if 
they had been received by a resident of Iceland who is not a 
U.S. citizen. The tax credit allowed under paragraph 4 with 
respect to such items need not exceed the U.S. tax that may be 
imposed under the Convention, other than 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, the United 
States will not reduce its tax below the amount that is taken 
into account in Iceland in applying 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 the United 
States 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). Clause (iii) of subparagraph 
3(c) of Article 24 (Mutual Agreement Procedure) provides a 
mechanism by which the competent authorities can resolve any 
disputes regarding whether income is from sources within the 
United States.
    The following two examples illustrate the application of 
paragraph 4 in the case of a U. S.-source portfolio dividend 
received by a U.S. citizen resident in Iceland. In both 
examples, the U.S. rate of tax on residents of Iceland, under 
subparagraph 2(b) of Article 10 (Dividends) of the Convention, 
is 15 percent. In both examples, the U.S. income tax rate on 
the U.S. citizen is 35 percent. In example 1, the rate of 
income tax imposed in Iceland on its resident (the U.S. 
citizen) is 25 percent (below the U.S. rate), and in example 2, 
the rate imposed on its resident is 40 percent (above the U.S. 
rate).

------------------------------------------------------------------------
                                                Example 1     Example 2
------------------------------------------------------------------------
Subparagraph (a)
U.S. dividend declared......................       $100.00       $100.00
Notional U.S. withholding tax (Article               15.00         15.00
 10(2)(b))..................................
Taxable income in Iceland...................        100.00        100.00
Icelandic tax before credit.................         25.00         40.00
Less: tax credit for notional U.S.                   15.00         15.00
 withholding tax............................
Net post-credit tax paid to Iceland.........         10.00         25.00
Subparagraphs (b) and (c)
U.S. pre-tax income.........................       $100.00       $100.00
U.S. pre-credit citizenship tax.............         35.00         35.00
Notional U.S. withholding tax...............         15.00         15.00
U.S. tax eligible to be offset by credit....         20.00         20.00
Tax paid to Iceland.........................         10.00         25.00
Income re-sourced from U.S. to foreign               28.57         57.14
 source (see below).........................
U.S. pre-credit tax on re-sourced income....         10.00         20.00
U.S. credit for tax paid to Iceland.........         10.00         20.00
Net post-credit U.S. tax....................         10.00          0.00
Total U.S. tax..............................         25.00         15.00
------------------------------------------------------------------------

    In both examples, in the application of subparagraph 4(a), 
Iceland credits a 15 percent U.S. tax against its residence tax 
on the U.S. citizen. In the first example, the net tax paid to 
Iceland after the foreign tax credit is $10.00; in the second 
example, it is $25.00. In the application of subparagraphs 4(b) 
and 4(c), from the U.S. tax due before credit of $35.00, the 
United States subtracts the amount of the U.S. source tax of 
$15.00, against which no U.S. foreign tax credit is allowed. 
This subtraction ensures that the United States collects the 
tax that it is due under the Convention as the State of source.
    In both examples, given the 35 percent U.S. tax rate, the 
maximum amount of U.S. tax against which credit for the tax 
paid to Iceland may be claimed is $20 ($35 U.S. tax minus $15 
U.S. withholding tax). Initially, all of the income in both 
examples was from sources within the United States. For a U.S. 
foreign tax credit to be allowed for the full amount of the tax 
paid to Iceland, an appropriate amount of the income must be 
re-sourced to Iceland under subparagraph 4(c).
    The amount that must be re-sourced depends on the amount of 
tax for which the U.S. citizen is claiming a U.S. foreign tax 
credit. In example 1, the tax paid to Iceland was $10. For this 
amount to be creditable against U.S. tax, $28.57 ($10 tax 
divided by 35 percent U.S. tax rate) must be resourced to 
Iceland. When the tax is credited against the $10 of U.S. tax 
on this resourced income, there is a net U.S. tax of $10 due 
after credit ($20 U.S. tax eligible to be offset by credit, 
minus $10 tax paid to Iceland). Thus, in example 1, there is a 
total of $25 in U.S. tax ($15 U.S. withholding tax plus $10 
residual U.S. tax).
    In example 2, the tax paid to Iceland was $25, but, because 
the United States subtracts the U.S. withholding tax of $15 
from the total U.S. tax of $35, only $20 of U.S. taxes may be 
offset by taxes paid to Iceland. Accordingly, the amount that 
must be resourced to Iceland is limited to the amount necessary 
to ensure a U.S. foreign tax credit for $20 of tax paid to 
Iceland, or $57.14 ($20 tax paid to Iceland divided by 35 
percent U.S. tax rate). When the tax paid to Iceland is 
credited against the U.S. tax on this re-sourced income, there 
is no residual U.S. tax ($20 U.S. tax minus $25 tax paid to 
Iceland, subject to the U.S. limit of $20). Thus, in example 2, 
there is a total of $15 in U.S. tax ($15 U.S. withholding tax 
plus $0 residual U.S. tax). Because the tax paid to Iceland was 
$25 and the U.S. tax eligible to be offset by credit was $20, 
there is $5 of excess foreign tax credit available for 
carryover.

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 the 
Article, 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)

    This Article ensures that nationals of a Contracting State, 
in the case of paragraph 1, and residents of a Contracting 
State, in the case of paragraphs 2 through 4, will not be 
subject, directly or indirectly, to discriminatory taxation in 
the other Contracting State. Not all differences in tax 
treatment, either as between nationals of the two States, or 
between residents of the two States, are violations of the 
prohibition against discrimination. Rather, the non-
discrimination obligations of this Article apply only if the 
nationals or residents of the two States are comparably 
situated.
    Each of the relevant paragraphs of the Article provides 
that two persons that arecomparably situated must be treated 
similarly. Although the actual words differ from paragraph to 
paragraph (e.g., paragraph 1 refers to two nationals ``in the 
same circumstances,'' paragraph 2 refers to two enterprises 
``carrying on the same activities'' and paragraph 4 refers to 
two enterprises that are ``similar''), the common underlying 
premise is that if the difference in treatment is directly 
related to a tax-relevant difference in the situations of the 
domestic and foreign persons being compared, that difference is 
not to be treated as discriminatory (i.e., if one person is 
taxable in a Contracting State on worldwide income and the 
other is not, or tax may be collectible from one person at a 
later stage, but not from the other, distinctions in treatment 
would be justified under paragraph 1). Other examples of such 
factors that can lead to non-discriminatory differences in 
treatment are noted in the discussions of each paragraph.
    The operative paragraphs of the Article also use different 
language to identify the kinds of differences in taxation 
treatment that will be considered discriminatory. For example, 
paragraphs 1 and 4 speak of ``any taxation or any requirement 
connected therewith that is more burdensome,'' while paragraph 
2 specifies that a tax ``shall not be less favorably levied.'' 
Regardless of these differences in language, only differences 
in tax treatment that materially disadvantage the foreign 
person relative to the domestic person are properly the subject 
of the Article.

Paragraph 1

    Paragraph 1 provides that a national of one Contracting 
State may not be subject to taxation or connected requirements 
in the other Contracting State that are different from or more 
burdensome than the taxes and connected requirements imposed 
upon a national of that other State in the same circumstances.
    The term ``national'' in relation to a Contracting State is 
defined in subparagraph 1(j) of Article 3 (General 
Definitions). The term includes both individuals and juridical 
persons.
    A national of a Contracting State is afforded protection 
under this paragraph even if the national is not a resident of 
either Contracting State. Thus, a U.S. citizen who is resident 
in a third country is entitled, under this paragraph, to the 
same treatment in Iceland as a national of Iceland who is in 
similar circumstances (i.e., presumably one who is resident in 
a third State).
    As noted above, whether or not the two persons are both 
taxable on worldwide income is a significant circumstance for 
this purpose. For this reason, paragraph 1 specifically states 
that the United States is not obligated to apply the same 
taxing regime to a national of Iceland who is not resident in 
the United States as it applies to a U.S. national who is not 
resident in the United States. United States citizens who are 
not residents of the United States but who are, nevertheless, 
subject to United States tax on their worldwide income are not 
in the same circumstances with respect to United States 
taxation as citizens of Iceland who are not United States 
residents. Thus, for example, Article 23 would not entitle a 
national of Iceland resident in a third country to taxation at 
graduated rates on U.S. source dividends or other investment 
income that applies to a U.S. citizen resident in the same 
third country.

Paragraph 2

    Paragraph 2 of the Article, provides that a Contracting 
State may not tax a permanent establishment of an enterprise of 
the other Contracting State less favorably than an enterprise 
of that first-mentioned State that is carrying on the same 
activities.
    The fact that a U.S. permanent establishment of an 
enterprise of Iceland is subject to U.S. tax only on income 
that is attributable to the permanent establishment, while a 
U.S. corporation engaged in the same activities is taxable on 
its worldwide income is not, in itself, a sufficient difference 
to provide different treatment for the permanent establishment. 
There are cases, however, where the two enterprises would not 
be similarly situated and differences in treatment may be 
warranted. For instance, it would not be a violation of the 
non-discrimination protection of paragraph 2 to require the 
foreign enterprise to provide information in a reasonable 
manner that may be different from the information requirements 
imposed on a resident enterprise, because information may not 
be as readily available to the Internal Revenue Service from a 
foreign as from a domestic enterprise. Similarly, it would not 
be a violation of paragraph 2 to impose penalties on persons 
who fail to comply with such a requirement (see, e.g., sections 
874(a) and 882(c)(2)). Further, a determination that income and 
expenses have been attributed or allocated to a permanent 
establishment in conformity with the principles of Article 7 
(Business Profits) implies that the attribution or allocation 
was not discriminatory.
    Section 1446 of the Code imposes on any partnership with 
income that is effectively connected with a U.S. trade or 
business the obligation to withhold tax on amounts allocable to 
a foreign partner. In the context of the Convention, this 
obligation applies with respect to a share of the partnership 
income of a partner resident in Iceland, and attributable to a 
U.S. permanent establishment. There is no similar obligation 
with respect to the distributive shares of U.S. resident 
partners. It is understood, however, that this distinction is 
not a form of discrimination within the meaning of paragraph 2 
of the Article. No distinction is made between U.S. and non-
U.S. partnerships, since the law requires that partnerships of 
both U.S. and non-U.S. domicile withhold tax in respect of the 
partnership shares of non-U.S. partners. Furthermore, in 
distinguishing between U.S. and non-U.S. partners, the 
requirement to withhold on the non-U.S. but not the U.S. 
partner's share is not discriminatory taxation, but, like other 
withholding on nonresident aliens, is merely a reasonable 
method for the collection of tax from persons who are not 
continually present in the United States, and as to whom it 
otherwise may be difficult for the United States to enforce its 
tax jurisdiction. If tax has been over-withheld, the partner 
can, as in other cases of over-withholding, file for a refund.
    Paragraph 2 does not obligate a Contracting State to grant 
to a resident of the other Contracting State any tax 
allowances, reliefs, etc., that it grants to its own residents 
on account of their civil status or family responsibilities. 
Thus, if a sole proprietor who is a resident of Iceland has a 
permanent establishment in the United States, in assessing 
income tax on the profits attributable to the permanent 
establishment, the United States is not obligated to allow to 
the resident of Iceland the personal allowances for himself and 
his family that he would be permitted to take if the permanent 
establishment were a sole proprietorship owned and operated by 
a U.S. resident, despite the fact that the individual income 
tax rates would apply.

Paragraph 3

    Paragraph 3 prohibits discrimination in the allowance of 
deductions. When a resident or an enterprise of a Contracting 
State pays interest, royalties or other disbursements to a 
resident of the other Contracting State, the first-mentioned 
Contracting State must allow a deduction for those payments in 
computing the taxable profits of the resident or enterprise as 
if the payment had been made under the same conditions to a 
resident of the first-mentioned Contracting State. Paragraph 3, 
however, does not require a Contracting State to give 
nonresidents more favorable treatment than it gives to its own 
residents. Consequently, a Contracting State does not have to 
allow nonresidents a deduction for items that are not 
deductible under its domestic law (for example, expenses of a 
capital nature).
    The term ``other disbursements'' is understood to include a 
reasonable allocation of executive and general administrative 
expenses, research and development expenses and other expenses 
incurred for the benefit of a group of related persons that 
includes the person incurring the expense.
    An exception to the rule of paragraph 3 is provided for 
cases where the provisions of paragraph 1 of Article 9 
(Associated Enterprises), paragraph 4 of Article 11 (Interest) 
or para-graph 6 of Article 12 (Royalties) apply. All of these 
provisions permit the denial of deductions in certain 
circumstances in respect of transactions between related 
persons. Neither State is forced to apply the non-
discrimination principle in such cases. The exception with 
respect to paragraph 4 of Article 11 would include the denial 
or deferral of certain interest deductions under Code section 
163(j).
    Paragraph 3 also provides that any debts of an enterprise 
of a Contracting State to a resident of the other Contracting 
State are deductible in the first-mentioned Contracting State 
for purposes of computing the capital tax of the enterprise 
under the same conditions as if the debt had been contracted to 
a resident of the first-mentioned Contracting State. Even 
though, for general purposes, the Convention covers only income 
taxes, under paragraph 6 of this Article, the nondiscrimination 
provisions apply to all taxes levied in both Contracting 
States, at all levels of government.

Paragraph 4

    Paragraph 4 requires that a Contracting State not impose 
more burdensome taxation or connected requirements on an 
enterprise of that State that is wholly or partly owned or 
controlled, directly or indirectly, by one or more residents of 
the other Contracting State than the taxation or connected 
requirements that it imposes on other similar enterprises of 
that first-mentioned Contracting State. For this purpose it is 
understood that ``similar'' refers to similar activities or 
ownership of the enterprise.
    This rule, like all non-discrimination provisions, does not 
prohibit differing treatment of entities that are in differing 
circumstances. Rather, a protected enterprise is only required 
to be treated in the same manner as other enterprises that, 
from the point of view of the application of the tax law, are 
in substantially similar circumstances both in law and in fact. 
The taxation of a distributing corporation under section 367(e) 
on an applicable distribution to foreign shareholders does not 
violate paragraph 4 of the Article because a foreign-owned 
corporation is not similar to a domestically-owned corporation 
that is accorded non-recognition treatment under sections 337 
and 355.
    For the reasons given above in connection with the 
discussion of paragraph 2 of the Article, it is also understood 
that the provision in section 1446 of the Code for withholding 
of tax on non-U.S. partners does not violate paragraph 5 of the 
Article.
    It is further understood that the ineligibility of a U.S. 
corporation with nonresident alien shareholders to make an 
election to be an ``S'' corporation does not violate paragraph 
4 of the Article. If a corporation elects to be an S 
corporation, it is generally not subject to income tax and the 
shareholders take into account their pro rata shares of the 
corporation's items of income, loss, deduction or credit. (The 
purpose of the provision is to allow an individual or small 
group of individuals the protections of conducting business in 
corporate form while paying taxes at individual rates as if the 
business were conducted directly.) A nonresident alien does not 
pay U.S. tax on a net basis, and, thus, does not generally take 
into account items of loss, deduction or credit. Thus, the S 
corporation provisions do not exclude corporations with 
nonresident alien shareholders because such shareholders are 
foreign, but only because they are not net-basis taxpayers. 
Similarly, the provisions exclude corporations with other types 
of shareholders where the purpose of the provisions cannot be 
fulfilled or their mechanics implemented. For example, 
corporations with corporate shareholders are excluded because 
the purpose of the provision to permit individuals to conduct a 
business in corporate form at individual tax rates would not be 
furthered by their inclusion.
    Finally, it is understood that paragraph 4 does not require 
a Contracting State to allow foreign corporations to join in 
filing a consolidated return with a domestic corporation or to 
allow similar benefits between domestic and foreign 
enterprises.

Paragraph 5

    Paragraph 5 of the Article confirms that no provision of 
the Article will prevent either Contracting State from imposing 
the branch profits tax described in paragraph 8 of Article 10 
(Dividends).

Paragraph 6

    As noted above, notwithstanding the specification of taxes 
covered by the Convention in Article 2 (Taxes Covered) for 
general purposes, for purposes of providing nondiscrimination 
protection this Article applies to taxes of every kind and 
description imposed by a Contracting State or a political 
subdivision or local authority thereof. Customs duties are not 
considered to be taxes for this purpose.

Relationship to Other Articles

    The saving clause of paragraph 4 of Article 1 (General 
Scope) does not apply to this Article by virtue of the 
exceptions in subparagraph 5(a) of Article 1. Thus, for 
example, a U.S. citizen who is a resident of Iceland may claim 
benefits in the United States under this Article.
    Nationals of a Contracting State may claim the benefits of 
paragraph 1 regardless of whether they are entitled to benefits 
under Article 21 (Limitation on Benefits), because that 
paragraph applies to nationals and not residents. They may not 
claim the benefits of the other paragraphs of this Article with 
respect to an item of income unless they are generally entitled 
to treaty benefits with respect to that income under a 
provision of Article 21.

                ARTICLE 24 (MUTUAL AGREEMENT PROCEDURE)

    This Article provides the mechanism for taxpayers to bring 
to the attention of competent authorities issues and problems 
that may arise under the Convention. It also provides the 
authority for cooperation between the competent authorities of 
the Contracting States to resolve disputes and clarify issues 
that may arise under the Convention and to resolve cases of 
double taxation not provided for in the Convention. The 
competent authorities of the two Contracting States are 
identified in subparagraph 1(i) of Article 3 (General 
Definitions).

Paragraph 1

    This paragraph provides that where a resident of a 
Contracting State considers that the actions of one or both 
Contracting States will result in taxation that is not in 
accordance with the Convention, he may present his case to the 
competent authority of either Contracting State. This rule is 
more generous than in most treaties, which generally allow 
taxpayers to bring competent authority cases only to the 
competent authority of their country of residence, or citizen-
ship/nationality. Under this more generous rule, a U.S. 
permanent establishment of a corporation resident in Iceland 
that faces inconsistent treatment in the two countries would be 
able to bring its request for assistance to the U.S. competent 
authority. If the U.S. competent authority can resolve the 
issue on its own, then the taxpayer need never involve the 
Icelandic competent authority. Thus, the rule provides 
flexibility that might result in greater efficiency.
    Although the typical cases brought under this paragraph 
will involve economic double taxation arising from transfer 
pricing adjustments, the scope of this paragraph is not limited 
to such cases. For example, a taxpayer could request assistance 
from the competent authority if one Contracting State 
determines that the taxpayer has received deferred compensation 
taxable at source under Article 14 (Income from Employment), 
while the taxpayer believes that such income should be treated 
as a pension that is taxable only in his country of residence 
pursuant to Article 17 (Pensions, Social Security, and 
Annuities).
    It is not necessary for a person requesting assistance 
first to have exhausted the remedies provided under the 
national laws of the Contracting States before presenting a 
case to the competent authorities, nor does the fact that the 
statute of limitations may have passed for seeking a refund 
preclude bringing a case to the competent authority. Unlike the 
OECD Model, no time limit is provided within which a case must 
be brought.

Paragraph 2

    Paragraph 2 sets out the framework within which the 
competent authorities will deal with cases brought by taxpayers 
under paragraph 1. It provides that, if the competent authority 
of the Contracting State to which the case is presented judges 
the case to have merit, and cannot reach a unilateral solution, 
it shall seek an agreement with the competent authority of the 
otherContracting State pursuant to which taxation not in 
accordance with the Convention will be avoided.
    Any agreement is to be implemented even if such 
implementation otherwise would be barred by the statute of 
limitations or by some other procedural limitation, such as a 
closing agreement. Paragraph 2, however, does not prevent the 
application of domestic-law procedural limitations that give 
effect to the agreement (e.g., a domestic-law requirement that 
the taxpayer file a return reflecting the agreement within one 
year of the date of the agreement).
    Where the taxpayer has entered a closing agreement (or 
other written settlement) with the United States before 
bringing a case to the competent authorities, the U.S. 
competent authority will endeavor only to obtain a correlative 
adjustment from Iceland. See  Rev. Proc. 2006-54, 2006-49 
I.R.B. 1035, Sec. 7.05. Because, as specified in paragraph 2 of 
Article 1 (General Scope), the Convention cannot operate to 
increase a taxpayer's liability, temporal or other procedural 
limitations can be overridden only for the purpose of making 
refunds and not to impose additional tax.

Paragraph 3

    Paragraph 3 authorizes the competent authorities to resolve 
difficulties or doubts that may arise as to the application or 
interpretation of the Convention. The paragraph includes a non- 
exhaustive list of examples of the kinds of matters about which 
the competent authorities may reach agreement. This list is 
purely illustrative; it does not grant any authority that is 
not implicitly present as a result of the introductory sentence 
of paragraph 3.
    The competent authorities may, for example, agree to the 
same allocation of income, deductions, credits or allowances 
between an enterprise in one Contracting State and its 
permanent establishment in the other or between related 
persons. These allocations are to be made in accordance with 
the arm's length principle underlying Article 7 (Business 
Profits) and Article 9 (Associated Enterprises). Agreements 
reached under these subparagraphs may include agreement on a 
methodology for determining an appropriate transfer price, on 
an acceptable range of results under that methodology, or on a 
common treatment of a taxpayer's cost sharing arrangement.
    As indicated in subparagraphs 3(a) through 3(f), the 
competent authorities also may agree to settle a variety of 
conflicting applications of the Convention. They may agree to 
settle conflicts regarding the characterization of particular 
items of income, including the same characterization of income 
that is assimilated to income from shares by the taxation law 
of one of the Contracting States and that is treated as a 
different class of income in the other State. They may also 
agree to the characterization of persons, the application of 
source rules to particular items of income, the meaning of a 
term, or the timing of an item of income.
    The competent authorities also may agree as to the 
application of the provisions of domestic law regarding 
penalties, fines, and interest in a manner consistent with the 
purposes of the Convention.
    Since the list under paragraph 3 is not exhaustive, the 
competent authorities may reach agreement on issues not 
enumerated in paragraph 3 if necessary to avoid double 
taxation. For example, the competent authorities may seek 
agreement on a uniform set of standards for the use of exchange 
rates. Agreements reached by the competent authorities under 
paragraph 3 need not conform to the internal law provisions of 
either Contracting State.
    Finally, paragraph 3 authorizes the competent authorities 
to consult for the purpose of eliminating double taxation in 
cases not provided for in the Convention and to resolve any 
difficulties or doubts arising as to the interpretation or 
application of the Convention. This provision is intended to 
permit the competent authorities to implement the treaty in 
particular cases in a manner that is consistent with its 
expressed general purposes. It permits the competent 
authorities to deal with cases that are within the spirit of 
the provisions but that are not specifically covered. An 
example of such a case might be double taxation arising from a 
transfer pricing adjustment between two permanent 
establishments of a third-country resident, one in the United 
States and one in Iceland. Since no resident of a Contracting 
State is involved in the case, the Convention does not apply, 
but the competent authorities nevertheless may use the 
authority of this Article to prevent the double taxation of 
income.

Paragraph 4

    Paragraph 4 provides that the competent authorities may 
communicate with each other for the purpose of reaching an 
agreement. This makes clear that the competent authorities of 
the two Contracting States may communicate without going 
through diplomatic channels. Such communication may be in 
various forms, including, where appropriate, through face-to-
face meetings of representatives of the competent authorities.

Treaty termination in relation to competent authority dispute 
        resolution

    A case may be raised by a taxpayer after the Convention has 
been terminated with respect to a year for which a treaty was 
in force. In such a case the ability of the competent 
authorities to act is limited. They may not exchange 
confidential information, nor may they reach a solution that 
varies from that specified in its law.

Triangular competent authority solutions

    International tax cases may involve more than two taxing 
jurisdictions (e.g., transactions among a parent corporation 
resident in country A and its subsidiaries resident in 
countries B and C). As long as there is a complete network of 
treaties among the three countries, it should be possible, 
under the full combination of bilateral authorities, for the 
competent authorities of the three States to work together on a 
three-sided solution. Although country A may not be able to 
give information received under Article 26 (Exchange of 
Information and Administrative Assistance) from country B to 
the authorities of country C, if the competent authorities of 
the three countries are working together, it should not be a 
problem for them to arrange for the authorities of country B to 
give the necessary information directly to the tax authorities 
of country C, as well as to those of country A. Each bilateral 
part of the trilateral solution must, of course, not exceed the 
scope of the authority of the competent authorities under the 
relevant bilateral treaty.

Relationship to Other Articles

    This Article is not subject to the saving clause of 
paragraph 4 of Article 1 (General Scope) by virtue of the 
exceptions in subparagraph 5(a) of that Article. Thus, rules, 
definitions, procedures, etc. that are agreed upon by the 
competent authorities under this Article may be applied by the 
United States with respect to its citizens and residents even 
if they differ from the comparable Code provisions. Similarly, 
as indicated above, U.S. law may be overridden to provide 
refunds of tax to a U.S. citizen or resident under this 
Article. A person may seek relief under Article 24 regardless 
of whether he is generally entitled to benefits under Article 
21 (Limitation on Benefits). As in all other cases, the 
competent authority is vested with the discretion to decide 
whether the claim for relief is justified.

   ARTICLE 25 (EXCHANGE OF INFORMATION AND ADMINISTRATIVE ASSISTANCE)

    This Article provides for the exchange of information and 
administrative assistance between the competent authorities of 
the Contracting States.

Paragraph 1

    The obligation to obtain and provide information to the 
other Contracting State is set out in paragraph 1. The 
information to be exchanged is that which is relevant for 
carrying out the provisions of the Convention or the domestic 
laws of the United States or of the Iceland concerning taxes of 
every kind applied at the national level. Exchange of 
information with respect to each State's domestic law is 
authorized to the extent that taxation under domestic law is 
not contrary to the Convention. Thus, for example, information 
may be exchanged with respect to a covered tax, even if the 
transaction to which the information relates is a purely 
domestic transaction in the requesting State and, therefore, 
the exchange is not made to carry out the Convention. An 
example of such a case is provided in the OECD Commentary: a 
company resident in the United States and a company resident in 
Iceland transact business between themselves through a third-
country resident company. Neither Contracting State has a 
treaty with the third State. To enforce their internal laws 
with respect to transactions of their residents with the third-
country company (since there is no relevant treaty in force), 
the Contracting States may exchange information regarding the 
prices that their residents paid in their transactions with the 
third-country resident.
    Paragraph 1 clarifies that information may be exchanged 
that relates 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 Convention. 
Thus, the competent authorities may request and provide 
information for cases under examination or criminal 
investigation, in collection, on appeals, or under prosecution.
    The taxes covered by the Convention for purposes of this 
Article constitute a broader category of taxes than those 
referred to in Article 2 (Taxes Covered). Exchange of 
information is authorized with respect to taxes of every kind 
imposed by a Contracting State at the national level. 
Accordingly, information may be exchanged with respect to U.S. 
estate and gift taxes, excise taxes or, with respect to 
Iceland, value added taxes.
    Information exchange is not restricted by paragraph 1 of 
Article 1 (General Scope). Accordingly, information may be 
requested and provided under this article with respect to 
persons who are not residents of either Contracting State. For 
example, if a third-country resident has a permanent 
establishment in Iceland, and that permanent establishment 
engages in transactions with a U.S. enterprise, the United 
States could request information with respect to that permanent 
establishment, even though the third-country resident is not a 
resident of either Contracting State. Similarly, if a third-
country resident maintains a bank account in Iceland, and the 
Internal Revenue Service has reason to believe that funds in 
that account should have been reported for U.S. tax purposes 
but have not been so reported, information can be requested 
from Iceland with respect to that person's account, even though 
that person is not the taxpayer under examination.
    Although the term ``United States'' does not encompass U.S. 
possessions for most purposes of the Convention, Section 7651 
of the Code authorizes the Internal Revenue Service to utilize 
the provisions of the Internal Revenue Code to obtain 
information from the U.S. possessions pursuant to a proper 
request made under Article 25. If necessary to obtain requested 
information, the Internal Revenue Service could issue and 
enforce an administrative summons to the taxpayer, a tax 
authority (or a government agency in a U.S. possession), or a 
third party located in a U.S. possession.
    Paragraph 1 also provides assurances that any information 
exchanged will be treated as secret, subject to the same 
disclosure constraints as information obtained under the laws 
of the requesting State. Information received may be disclosed 
only to persons, including courts and administrative bodies, 
involved in the assessment, collection, or administration of, 
the enforcement or prosecution in respect of, or the 
determination of the of appeals in relation to, the taxes 
covered by the Convention. The information must be used by 
these persons in connection with the specified functions. 
Information may also be disclosed to legislative bodies, such 
as the tax-writing committees of Congress and the Government 
Accountability Office, engaged in the oversight of the 
preceding activities. Information received by these bodies must 
be for use in the performance of their role in overseeing the 
administration of U.S. tax laws. Information received may be 
disclosed in public court proceedings or in judicial decisions.

Paragraph 2

    Paragraph 2 provides that when information is requested by 
a Contracting State in accordance with this Article, the other 
Contracting State is obligated to obtain the requested 
information as if the tax in question were the tax of the 
requested State, even if that State has no direct tax interest 
in the case to which the request relates. In the absence of 
such a paragraph, some taxpayers have argued that subparagraph 
3(a) prevents a Contracting State from requesting information 
from a bank or fiduciary that the Contracting State does not 
need for its own tax purposes. This paragraph clarifies that 
paragraph 3 does not impose such a restriction and that a 
Contracting State is not limited to providing only the 
information that it already has in its own files.

Paragraph 3

    Paragraph 3 provides that the obligations undertaken in 
paragraphs 1 and 2 to exchange information do not require a 
Contracting State to carry out administrative measures that are 
at variance with the laws or administrative practice of either 
State. Nor is a Contracting State required to supply 
information not obtainable under the laws or administrative 
practice of either State, or to disclose trade secrets or other 
information, the disclosure of which would be contrary to 
public policy.
    Thus, a requesting State may be denied information from the 
other State if the information would be obtained pursuant to 
procedures or measures that are broader than those available in 
the requesting State. However, the statute of limitations of 
the Contracting State making the request for information should 
govern a request for information. Thus, the Contracting State 
of which the request is made should attempt to obtain the 
information even if its own statute of limitations has passed. 
In many cases, relevant information will still exist in the 
business records of the taxpayer or a third party, even though 
it is no longer required to be kept for domestic tax purposes.
    While paragraph 3 states conditions under which a 
Contracting State is not obligated to comply with a request 
from the other Contracting State for information, the requested 
State is not precluded from providing such information, and 
may, at its discretion, do so subject to the limitations of its 
internal law.
    Paragraph 7 of the Protocol provides that the powers of 
each Contracting State's competent authority to obtain 
information include powers to obtain information held by 
financial institutions, nominees, or persons acting in an 
agency or fiduciary capacity (not including information that 
would reveal confidential communications between a client and 
an attorney, solicitor, or other legal representative, where 
the client seeks legal advice), and information relating to the 
ownership of legal persons. Paragraph 7 of the Protocol 
acknowledges that each Contracting State's competent authority 
is able to exchange such information in accordance with Article 
25. The provisions of paragraph 7 of the Protocol prevent a 
Contracting State from relying on paragraph 3 of the Convention 
to argue that its domestic bank secrecy laws (or similar 
legislation relating to disclosure of financial information by 
financial institutions or intermediaries) override its 
obligation to provide information under paragraph 1.

Paragraph 4

    Paragraph 4 provides that the requesting State may specify 
the form in which information is to be provided (e.g., 
depositions of witnesses and authenticated copies of original 
documents).
    The intention is to ensure that the information may be 
introduced as evidence in the judicial proceedings of the 
requesting State. The requested State should, if possible, 
provide the information in the form requested to the same 
extent that it can obtain information in that form under its 
own laws and administrative practices with respect to its own 
taxes.

Paragraph 5

    Paragraph 5 provides for assistance in collection of taxes 
to the extent necessary to ensure that treaty benefits are 
enjoyed only by persons entitled to those benefits under the 
terms of the Convention. Under paragraph 5, a Contracting State 
will endeavor to collect on behalf of the other State only 
those amounts necessary to ensure that any exemption or reduced 
rate of tax at source granted under the Convention by that 
other State is not enjoyed by persons not entitled to those 
benefits. For example, if the payer of a U.S.-source portfolio 
dividend receives a Form W-8BEN or other appropriate 
documentation from the payee, the withholding agent is 
permitted to withhold at the portfolio dividend rate of 15 
percent. If, however, the addressee is merely acting as a 
nominee on behalf of a third-country resident, paragraph 5 
would obligate the other Iceland to withhold and remit to the 
United States the additional tax that should have been 
collected by the U.S. withholding agent.
    This paragraph also makes clear that the Contracting State 
asked to collect the tax is not obligated, in the process of 
providing collection assistance, to carry out administrative 
measures that are different from those used in the collection 
of its own taxes, or that would be contrary to its sovereignty, 
security or public policy.

Paragraph 6

    Paragraph 6 provides that a Contracting State must notify 
the competent authority of the other Contracting State before 
sending representatives to enter the requested State to 
interview individuals and examine books and records with the 
consent of the persons subject to examination.

     ARTICLE 26 (MEMBERS OF DIPLOMATIC MISSIONS AND CONSULAR POSTS)

    This Article confirms that any fiscal privileges to which 
diplomatic or consular officials are entitled under general 
provisions of international law or under special agreements 
will apply notwithstanding any provisions to the contrary in 
the Convention. The agreements referred to include any 
bilateral agreements, such as consular conventions, that affect 
the taxation of diplomats and consular officials and any 
multilateral agreements dealing with these issues, such as the 
Vienna Convention on Diplomatic Relations and the Vienna 
Convention on Consular Relations. The U.S. generally adheres to 
the latter because its terms are consistent with customary 
international law.
    The Article does not independently provide any benefits to 
diplomatic agents and consular officers. Article 18 (Government 
Service) does so, as do Code section 893 and a number of 
bilateral and multilateral agreements. In the event that there 
is a conflict between the Convention and international law or 
such other treaties, under which the diplomatic agent or 
consular official is entitled to greater benefits under the 
latter, the latter laws or agreements shall have precedence. 
Conversely, if the Convention confers a greater benefit than 
another agreement, the affected person could claim the benefit 
of the tax treaty.
    Pursuant to subparagraph 5(b) of Article 1 (General Scope), 
the saving clause of paragraph 4 of Article 1 does not apply to 
override any benefits of this Article available to an 
individual who is neither a citizen of the United States nor 
has immigrant status in the United States.

                     ARTICLE 27 (ENTRY INTO FORCE)

    This Article contains the rules for bringing the Convention 
into force and giving effect to its provisions.

Paragraph 1

    Paragraph 1 provides that the Convention is subject to 
ratification in accordance with the applicable procedures of 
the United States and Iceland. Further, the Contracting States 
shall notify each other by written notification, through 
diplomatic channels, when their respective applicable 
procedures have been satisfied.
    In the United States, the process leading to ratification 
and entry into force is as follows: Once a treaty has been 
signed by authorized representatives of the two Contracting 
States, the Department of State sends the treaty to the 
President who formally transmits it to the Senate for its 
advice and consent to ratification, which requires approval by 
two-thirds of the Senators present and voting. Prior to this 
vote, however, it generally has been the practice for the 
Senate Committee on Foreign Relations to hold hearings on the 
treaty and make a recommendation regarding its approval to the 
full Senate. Both Government and private sector witnesses may 
testify at these hearings. After the Senate gives its advice 
and consent to ratification of the treaty, an instrument of 
ratification is drafted for the President's signature. 
ThePresident's signature completes the process in the United 
States.

Paragraph 2

    Paragraph 2 provides that the Convention will enter into 
force on the date of the later of the notifications referred to 
in paragraph 1. The relevant date is the date on the second of 
these notification documents, and not the date on which the 
second notification is provided to the other Contracting State. 
The date on which a treaty enters into force is not necessarily 
the date on which its provisions take effect. Paragraph 2, 
therefore, also contains rules that determine when the 
provisions of the treaty will have effect.
    Under subparagraph 2(a), the Convention will have effect 
with respect to taxes withheld at source (principally 
dividends, interest and royalties) for income derived on or 
after the first day of January in the first calendar year 
following the date on which the Convention enters into force. 
For all other taxes, subparagraph 2(b) specifies that the 
Convention will have effect for taxes chargeable for any tax 
year beginning on or after January 1 of the year following 
entry into force.

Paragraph 3

    Paragraph 3 provides an exception to the general rule of 
paragraph 2. Under paragraph 3, if the prior income tax 
convention between the United States and Iceland would have 
afforded greater relief from tax than this Convention, that 
prior convention shall, at the election of any person that was 
entitled to benefits under the prior convention, continue to 
have effect in its entirety for a twelve-month period from the 
date on which this Convention otherwise would have had effect 
with respect to such person.
    Thus, a taxpayer may elect to extend the benefits of the 
prior convention for one year from the date on which the 
relevant provision of the new Convention would first take 
effect. During the period in which the election is in effect, 
the provisions of the prior convention will continue to apply 
only insofar as they applied before the entry into force of the 
Convention. If the grace period is elected, all of the 
provisions of the prior convention must be applied for that 
additional year. The taxpayer may not apply certain, more 
favorable provisions of the prior convention and, at the same 
time, apply other, more favorable provisions of this 
Convention. The taxpayer must choose one convention in its 
entirety or the other.
    The prior convention shall terminate on the last date on 
which it has effect with respect to any tax in accordance with 
the provisions of Article 28.

Paragraph 4

    Paragraph 4 provides that an individual who was entitled to 
benefits under Article 21 (Teachers) of the prior convention at 
the time of the entry into force of this Convention is 
``grandfathered,'' and will continue to be entitled to the 
benefits available under the prior convention until such time 
as that individual would cease to be entitled to benefits if 
the prior convention remained in force.

                        ARTICLE 28 (TERMINATION)

    The Convention is to remain in effect indefinitely, unless 
terminated by one of the Contracting States in accordance with 
the provisions of Article 28. The Convention may be terminated 
by giving notice of termination in writing at least six months 
before the end of any calendar year. If notice of termination 
is given, the provisions of the Convention with respect to 
withholding at source will cease to have effect on income 
derived on or after the first day of January in the first 
calendar year following the year in which notice is given. For 
other taxes, the Convention will cease to have effect for taxes 
chargeable for any tax year beginning on or after the first day 
of January in the first calendar year following the year in 
which notice is given.
    Article 28 relates only to unilateral termination of the 
Convention by a Contracting State. Nothing in that Article 
should be construed as preventing the Contracting States from 
concluding a new bilateral agreement, subject to ratification, 
that supersedes, amends or terminates provisions of the 
Convention without the notification period.
    Customary international law observed by the United States 
and other countries, as reflected in the Vienna Convention on 
Treaties, allows termination by one Contracting State at any 
time in the event of a ``material breach'' of the agreement by 
the other Contracting State.

                                    

      
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