In general, the proposed treaty provides that the branch profits tax may be imposed by the source country only on that portion of the business profits of the foreign corporation attributable to its source country permanent establishment, or the corporation's real property income subject to tax on a net basis. In general, the branch profits tax may also be imposed by the source country on corporation's gains from the disposition of real property. However, the branch profits tax may not be imposed on income of the foreign corporation that is, under the proposed treaty, subject to tax by the source country as source country real property gains from the disposition of shares or other comparable corporate rights in a company.31 For example, the United States may not impose branch profits tax on the income of a Dutch corporation from the sale of stock in a U.S. real property holding company.

The profit, income, or gain to be subjected to the branch profits tax must be reduced for all source country taxes chargeable on it, other than the branch profits tax. The taxable portion must be further reduced (but not below zero) by any increase for the year in the permanent establishment's net equity. By the same token, the taxable portion is increased by any decrease for the year in the permanent establishment's net equity. However, the latter increase cannot exceed the foreign corporation's accumulated profits, defined for any future year as the excess of (a) the foreign corporation's_aggregate source-country profits for all then-prior taxable years during which the proposed treaty was in effect, over (b) the aggregate profits taxed under the branch profits tax during those prior years. The proposed treaty permits the United States to impose its branch profits tax on the "dividend equivalent amount" (as that term is defined under the Code as it may be amended from time to time) to the extent that this definition is in conformity with the principles of the branch tax article. Currently the dividend equivalent amount of business profits attributable to a permanent establishment generally is the earnings and profits attributable to a U.S. permanent establishment, plus an additional amount representing any decreases in the permanent establishment's "U.S. net equity and minus an amount representing any increase in the permanent establishment's U.S. net equity.

In light of the similarity between U.S. law and the principles laid down in the branch tax article, the Technical Explanation indicates that the proposed treaty permits the United States to impose the branch profits tax as set forth currently under section 884, so long as its operation is limited to the earnings of a Dutch corporation either from its U.S. permanent establishment or U.S. real property income and gains (other than stock gains from dispositions of stock in a U.S. real property holding company), and then only those amounts earned in years during which the proposed treaty is in effect.

None of the restrictions on the operation of U.S. or Dutch internal law branch tax provisions apply, however, unless the corporation seeking treaty protection meets the conditions of the proposed treaty's limitation on benefits article (Article 26). As described in

31 The conditions under which such stock gains are taxable in country where the real property is situated are discussed below in connection with Article 14 (Capital Gains).

the discussion of Article 26 below, the limitation on benefits requirements of the proposed treaty are in some ways similar, but not identical, to the analogous provisions of the branch profits tax provisions of the Code described above.

Article 12. Interest

United States internal law

Subject to numerous exceptions (such as those for portfolio interest, bank deposit interest, and short term original issue discount), the United States imposes a 30-percent tax on U.S. source interest paid to foreign persons under the same rules that apply to dividends. U.S. source interest, for purposes of the 30-percent tax, generally is interest on the debt obligations of a U.S. person, other than a U.S. person that meets the foreign business requirements of Code section 861(c) (e.g., an 80/20 company). Also subject to the 30-percent tax is interest paid to a foreign person by the U.S. trade or business of a foreign corporation. A foreign corporation is also subject to a branch level excess interest tax, which is the tax it would have paid had a wholly owned domestic corporation paid it the interest deducted by the foreign corporation in computing its U.S. effectively connected income but not paid by the U.S. trade or business (sec. 884(f)).

Portfolio interest generally is defined as any U.S. source interest that is not effectively connected with the conduct of a trade or business and (1) is paid on an obligation that satisfies certain registration requirements or specified exceptions thereto, and (2) is not received by a 10-percent owner of the issuer of the obligation, taking into account shares owned by attribution.32

Under a provision enacted in the Omnibus Budget Reconciliation Act of 1993, the portfolio interest exemption is inapplicable to certain contingent interest income. For this purpose, contingent interest generally includes interest determined by reference to any of the following attributes of the debtor or any related person: receipts, sales, or other cash flow; income or profits; or changes in the value of property. In addition, contingent interest generally includes interest determined by reference to any dividend, partnership distribution, or similar payment made by the debtor or a related person. A number of exceptions apply, including an exception for interest determined by reference to changes in the value of, or yields on, certain actively traded property. In the case of an instrument on which a foreign holder earns both contingent and non-contingent interest, denial of the portfolio interest exemption applies only to the portion of the interest which is contingent interest.

If an investor holds an interest in a fixed pool of real estate mortgages that is a real estate mortgage interest conduit (REMIC), the REMIC is treated generally for U.S. tax purposes as a passthrough entity and the investor is subject to U.S. tax on some portion of the REMIC's income (which in turn is generally interest income). If the investor holds a so-called "residual interest" in the

32 Certain additional exceptions to this general rule apply only in the case of a corporate recipient of interest. In such a case, the term portfolio interest generally excludes (1) interest received by a bank on a loan extended in the ordinary course of its business (except in the case of interest paid on an obligation of the United States), and (2) interest received by a controlled foreign corporation from a related person.

REMIC, the Code provides that a portion of the net income of the REMIC that is taxed in the hands of the investor-referred to as the investor's "excess inclusion"-may not be offset by any net operating losses of the investor, must be treated as unrelated business income if the investor is an organization subject to the unrelated business income tax under section 511, and is not eligible for any reduction in the 30-percent rate of withholding tax (by treaty or otherwise) that would apply if the investor were otherwise eligible for such a rate reduction.

Netherlands internal law

The Netherlands generally does not impose tax on interest income of nonresidents, unless the interest income is earned in connection with a Dutch permanent establishment. As described above in connection with the dividend article, the Dutch dividend tax applies to proceeds from profit sharing bonds, and under the present treaty, such proceeds are treated as dividends rather than interest for Dutch withholding purposes. In addition, a nonresident individual or corporation may be subject to Dutch tax on net income derived from bonds or debts issued by a Dutch corporation, if the recipient owns a substantial interest in the corporation.

Proposed treaty limitations on internal laws

The proposed treaty generally provides that interest arising in one treaty country and beneficially owned by a resident of the other country may be taxed only by latter country, and not the country where the interest arose. That is, such income may not be taxed in the "source country." No such exemption applies, however, to an excess inclusion with respect to a residual interest in a REMIC. Thus, such inclusions may be taxed at 30 percent consistently with the proposed treaty. The proposed treaty does exempt Dutch corporations from imposition by the United States of the branch level excess interest tax. The proposed treaty thus generally exempts from the U.S. 30-percent tax on U.S. source interest paid to foreign persons, interest (within the treaty definition of that term) paid to Dutch residents. The treaty also exempts from Dutch taxes, in those few cases where any such tax might otherwise be applicable, Dutch source interest paid to U.S. residents. These reciprocal exemptions are similar to those in effect under the present treaty and in the U.S. model treaty.

The exemptions apply only if the interest is beneficially owned by a resident of one of the countries. Accordingly, they do not apply if the recipient of the interest is a nominee for a nonresident.

In addition, the exemptions will not apply if the beneficial owner of the interest carries on a business through a permanent establishment (or fixed base in the case of an individual who performs independent personal services) in the source country and the interest paid is attributable to the permanent establishment (or fixed base). In that event, the interest will be taxed as business profits (Article 7) or income from the performance of independent personal services (Article 15). In such a case, the effect of the deferred payment rules for determining U.S.-effectively connected income under the Code (sec 864(c)(6)) on Dutch residents eligible for treaty bene

fits are dealt with in Article 24 (Basis of Taxation) of the proposed treaty.

The proposed treaty addresses the issue of non-arm's-length interest charges between related parties (or parties having an otherwise special relationship) by stating that the amount of interest for purposes of applying this article will be the amount of arm's-length interest. Any amount of interest paid in excess of the arm's-length interest will be taxable according to the laws of each country, taking into account the other provisions of the proposed treaty. For example, excess interest paid to a parent corporation may be treated as a dividend under local law and thus be entitled to the benefits of Article 10 of the proposed treaty. As explained above in connection with Article 9 (Associated Enterprises), the Understanding provides guidance on the application of this paragraph.

Definition of interest

The treaty defines interest generally as income from debt-claims of every kind, whether or not secured by mortgage, and not carrying a right to participate in the debtor's profits. In particular, it includes income from government securities and from bonds or debentures, including premiums or prizes attaching to such securities, bonds, or debentures. The treaty also defines interest to include an excess inclusion with respect to a REMIC, and other income that is treated as income from money lent by the taxation law of the source country. However, the term does not include income dealt with in the dividend article (Article 10). Thus, the interest exemption does not prevent the Netherlands from imposing the dividend tax on interest paid on profit sharing bonds, nor (staff understands) does it prevent the United States from imposing its withholding tax on contingent interest under the portfolio interest rules as amended in the 1993 Act. Penalty charges for late payment are not interest for purposes of the proposed treaty.

Source rule

The proposed treaty explicates what it means under the treaty for interest to arise in (i.e., to have its source in) a particular country. In general, interest will be deemed to arise in one of the treaty countries when the payor is that country itself, or a political subdivision, a local authority, or a resident of that country. However, an overriding rule applies in some cases where the payor (whether or not a resident of the United States or the Netherlands) has a permanent establishment or a fixed base in one of the treaty countries (and the debt on which the interest is paid was incurred in connection with that permanent establishment or fixed base), or has income otherwise subject to the branch profits tax in one of those countries. In such a case the interest is deemed to arise in the country in which the permanent establishment or fixed base is located, or in which the branch profits tax may be imposed. This rule applies only if the interest is borne by the permanent establishment or fixed base, or is allocable to the income subject to the branch tax.

Thus, for example, interest paid to a Dutch resident by the U.S. branch of a French company may be considered U.S. source income under the proposed treaty and therefore be exempt by treaty from

U.S. tax. In addition, if a Dutch company has a U.S. permanent establishment, then interest paid by the company that is deductible against the U.S.-taxable income of the U.S. branch is deemed to be U.S. source income, even if that interest is not paid by the U.S. permanent establishment.

Second-level withholding, and branch level tax, on interest

The proposed treaty contains a general limitation on the taxation of interest paid by residents of the other country. Under this provision, the Netherlands may not impose any tax on interest paid by a U.S. resident except where the interest is paid to a Dutch resident, is attributable to a permanent establishment or a fixed base situated in the Netherlands, or is Dutch source interest which is not paid to a U.S. resident. Similarly, the United States may not impose any tax on interest paid by a Dutch resident except where the interest is paid to a U.S. resident, is attributable to a U.S. permanent establishment or a fixed base, or is U.S. source interest which is not paid to a Dutch resident. For example, the provision permits the United States to impose withholding tax on interest paid by the U.S. permanent establishment of a Dutch corporation to a Canadian resident. The staff understands that the proposed treaty does not affect the right of the United States to impose income tax on the interest income of a third-country resident received from a Dutch resident (e.g., the interest income of a U.S. trade or business conducted by a Canadian corporation), because the proposed treaty generally applies only to persons who are residents of one or both of the treaty countries.

The proposed treaty contains language that exempts Dutch companies from the U.S. branch level excess interest tax by treating the excess interest as derived and beneficially owned by a Dutch resident. As explained above in connection with the source rule, such interest is treated as U.S. source interest. Thus, under the language described in the previous paragraph, the United States would be permitted to tax such interest if it were paid to someone other than a Dutch resident. The proposed treaty further provides, however, where the payer of interest is a resident of one of the treaty countries and has a permanent establishment in the other country, or has income otherwise subject to the branch profits tax, then to the extent that the amount of interest arising in the second country by reason of the permanent establishment or by reason of income subject to the branch profits tax exceeds the total amount of interest paid by the permanent establishment or in connection with income otherwise subject to the branch profits tax, this excess is treated as interest derived and beneficially owned by a resident of the first country.

Article 13. Royalties

Internal law

Under the same system that applies to dividends and interest, the United States imposes a 30-percent tax on U.S. source royalties paid to foreign persons, and on gains from the disposition of certain intangible property to the extent that gains are from payments con