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 Adminis- trative 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 

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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 894(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). 

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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. 

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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 

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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 (NonDiscrimination) 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 

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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 nontax 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 

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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 

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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 international 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 

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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 81-100 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 

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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 

11
 
"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 

12
 
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, 

13
 
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 

14
 
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 

15
 
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 con- trols, 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. § 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 

16
 
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. 

17
 
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. 

18
 
 

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 

19
 
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 

20
 
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 manu- factured 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. 

21
 
 

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 

22
 
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 

23
 
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. 

24
 
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. 

25
 
 

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 recharacterizing 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. 

26
 
 

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. 

27
 
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 (NonDiscrimination). 

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 

28
 
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 

29
 
 

 

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. 

30
 
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. 

31
 
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) 

32
 
 

 

 

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 

33
 
 

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's34
 
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). 

35
 
 

 

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 

36
 
 

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 

37
 
 

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). 

Relationship 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). 

38
 
 

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 assetratio 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. 

39
 
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. 

40
 
 

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 

41
 
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. 

42
 
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 

43
 
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 hostcountry 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. 

44
 
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 hostcountry tax because the company earns business profits but has no permanent establishment in 

that country. The performer may largely or entirely escape host-country tax by receiving only a 

small salary, perhaps small enough to place him below the dollar threshold in paragraph 1. 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 apply 

to 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. 

45
 
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 

46
 
 

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 resi- dent 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. 

47
 
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. 

48
 
 

 

 

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 

49
 
 

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 

50
 
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. 

51
 
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. 

52
 
 

 

 

 

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. 

53
 
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 

54
 
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, 

55
 
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. 

56
 
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. 

57
 
 

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 

58
 
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 367(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 incomeproducing 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 

59
 
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 

IceSub 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 

60
 
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 

61
 
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 

62
 
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. 

63
 
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. 

64
 
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). 

65
 
 

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). 

 Subparagraph (a) 

Example 1 Example 2

U.S. dividend declared $100.00 $100.00 

Notional U.S. withholding tax (Article 10(2)(b))

Taxable income in Iceland 

15.00 

100.00 

15.00 

100.00 

Icelandic tax before credit 25.00 40.00 

Less: tax credit for notional U.S. withholding tax

Net post-credit tax paid to Iceland 

15.00 

10.00 

15.00 

25.00 

Subparagraphs (b) and (c) 

U.S. pre-tax income $100.00 

U.S. pre-credit citizenship tax 35.00 

Notional U.S. withholding tax 15.00 

U.S. tax eligible to be offset by credit 20.00 

Tax paid to Iceland 10.00 

Income re-sourced from U.S. to foreign source (see below) 28.57 

U.S. pre-credit tax on re-sourced income 10.00 

U.S. credit for tax paid to Iceland 10.00 

Net post-credit U.S. tax 10.00 

Total U.S. tax 25.00 

$100.00 

35.00 

15.00 

20.00 

25.00 

57.14 

20.00 

20.00 

0.00 

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 

66
 
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 are

comparably situated must be treated similarly. Although the actual words differ from paragraph 

67
 
 

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 

68
 
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 nonU.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). 

69
 
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 firstmentioned 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 

70
 
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 

71
 
 

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 other 

Contracting 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, § 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 

72
 
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. 

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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 

74
 
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. 

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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). 

76
 
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. 

77
 
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. The 

President'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 

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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. 

79