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ARTICLE 7 - Business ProfitsThis Article provides rules for the taxation by a Contracting State of the business profits of an enterprise of the other Contracting State. Paragraph 1Paragraph 1 states the general rule that business profits (as defined in paragraph 7) 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, but only on a net basis. Under certain circumstances, the State in which the permanent establishment exists may also tax income of the enterprise attributable to sales in that other State of goods or merchandise of the same kind as those sold through the permanent establishment, or to other business transactions carried on in that other State which are of the same or similar kind as those effected through the permanent establishment. These rules are of a type known as ``limited force of attraction'' rules. This limited force of attraction rule is similar to, but narrower than, a rule found in the U.N. Model. Under the rule in the U.N. Model, if an enterprise of one Contracting State derives income from the sale of goods or the carrying on of other business activities through a permanent establishment situated in the other Contracting State, income derived directly by the enterprise (i.e., not through the permanent establishment) from the sale of goods of the same or similar kind as those sold through the permanent establishment or from the carrying on of activities of the same or similar kind as those carried on through the permanent establishment may be attributed to the permanent establishment. Countries that insist on including a limited force of attraction rule see it as a means of preventing avoidance of their tax at source. The force of attraction rule in this Convention focuses on its anti-abuse function. Its application is limited to situations in which it can be shown that the transaction giving rise to the income was carried out outside the permanent establishment in order to avoid taxation in the country in which the permanent establishment is situated. For example, if the Vilnius office of a U.S. consulting firm provides certain services to small companies in Lithuania and a very large Lithuanian company requires similar services but on a scale too large for the permanent establishment to handle, the Lithuanian company might enter into a contract with the consulting firm's home office in the United States to provide those services directly. The income from that transaction would not be attributed to the permanent establishment because it could not be shown that the transaction was structured through the U.S. office in order to avoid Lithuanian tax. If, however, some small Lithuanian companies are served by the Vilnius office and other similar-sized companies are served directly from the United States, it might be possible to show that services were carried out through the home office to avoid Lithuanian tax. If such a case were made, the income from these contracts with the home office would be attributed to the permanent establishment. The limited force of attraction rule in this Convention is narrower than the rule of Code section 864(c)(3). Paragraph 2Paragraph 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 an independent enterprise engaged in the same or similar activities under the same or similar circumstances. This language incorporates the arm's length standard for purposes of determining the profits attributable to a permanent establishment. The computation of business profits attributable to a permanent establishment under this paragraph is subject to the rules of paragraph 3 for the allowance of expenses incurred for the purposes of earning the profits. The ``attributable to'' concept of paragraph 2 is analogous but not entirely equivalent to the ``effectively connected'' concept in Code section 864(c). The profits attributable to a permanent establishment may be from sources within or without a Contracting State. It is understood that the business profits attributed to a permanent establishment include only those profits derived from that permanent establishment's assets or activities. This rule is consistent with the ``asset-use'' and ``business activities'' test of Code section 864(c)(2). Thus, the limited force of attraction rule of Code section 864(c)(3) is not incorporated into paragraph 2. This Article does not contain a provision corresponding to paragraph 4 of Article 7 of the OECD Model. That paragraph provides that a Contracting State in certain circumstances may determine the profits attributable to a permanent establishment on the basis of an apportionment of the total profits of the enterprise. The inclusion of such a paragraph is unnecessary. Paragraphs 2 and 3 of Article 7 authorize the use of such approaches independently of paragraph 4 of Article 7 of the OECD Model because total profits methods are acceptable methods for determining the arm's length profits of an enterprise under Article 9. Any such approach, however, must be designed to approximate an arm's length result. Accordingly, it is understood that under paragraph 2 of the Convention, it is permissible to use methods other than separate accounting to estimate the arm's length profits of a permanent establishment where it is necessary to do so for practical reasons, such as when the affairs of the permanent establishment are so closely bound up with those of the head office that it would be impossible to disentangle them on any strict basis of accounts. Paragraph 3This paragraph is in substance the same as paragraph 3 of Article 7 of the U.S. Model. 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. Whereas the U.S. Model explicitly states that deductions are not limited to expenses incurred exclusively for the purposes of the permanent establishment, in this treaty, like the OECD model, it is implicitly understood that there will be allowed a reasonable allocation to the permanent establishment of expenses incurred by the enterprise, whether those expenses were incurred for purposes of the enterprise as a whole, or they were incurred for the part of the enterprise that includes the permanent establishment, see paragraph 16 of the Commentaries to Article 7 of the OECD Model. 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 if properly allocable thereto. The paragraph specifies that the expenses that may be considered to be incurred for the purposes of the permanent establishment are expenses for research and development, interest and other similar expenses, as well as a reasonable amount of executive and general administrative expenses. This rule permits (but does not require) each Contracting State to apply the type of expense allocation rules provided by U.S. law (such as in Treas. Reg. sections 1.861-8 and 1.882- 5). Paragraph 3 does not permit a deduction for expenses charged to a permanent establishment by another unit of the enterprise. Thus, a permanent establishment may not deduct a royalty deemed paid to the head office. Similarly, a permanent establishment may not increase its business profits by the amount of any notional fees for ancillary services performed for another unit of the enterprise, but also should not receive a deduction for the expense of providing such services, since those expenses would be incurred for purposes of a business unit other than the permanent establishment. The last sentence of the paragraph, which is neither in the U.S. Model nor in the OECD Model, allows each Contracting State, consistent with its law, to impose limitations on the deductions taken by the permanent establishment as long as the limitations are consistent with the concept of net income. This language was provided at the request of the Lithuanian delegation. The language allows the United States and Lithuania to place limits on certain deductions, for example, entertainment expenses. However, it would not permit the Contracting States to deny a deduction for wages or interest expenses since such expenses are so fundamental that denial of deductions would be inconsistent with the concept of net income. Paragraph 4Paragraph 4 permits the tax authorities of a Contracting State to apply the provisions of internal law in determining tax liability in cases where the information available to the competent authority is not adequate to measure accurately the profits of a permanent establishment. The Internal Revenue Service would have this power even in the absence of such a specific provision. The determination of profits in such cases, based on the available information, must be done consistently with the principles of this Article, i.e., it must seek to reflect arm's length pricing and appropriate deductions of expenses. Paragraph 5Paragraph 5 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 identical to paragraph 4 of the U.S. 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 permanent establishment is the purchase of goods or merchandise because such activity does not give rise to a permanent establishment under Article 5 (Permanent Establishment). A common situation in which paragraph 4 is relevant is one in which a permanent establishment purchases raw materials for the enterprise's manufacturing operation conducted outside the United States and sells the manufactured product. While business profits may be attributable to the permanent establishment with respect to its sales activities, no profits are attributable to it with respect to its purchasing activities. Paragraph 6This paragraph tracks paragraph 5 of Article 7 of the U.S. Model, providing 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. Paragraph 7The term ``business profits'' is broadly defined in paragraph 7 to mean income derived from any trade or business. Specific examples that are not meant to be comprehensive include profits from manufacturing, mercantile, fishing, transportation, communications or extractive activities. Business profits also include income from the furnishing of the personal services of other persons, but as the second sentence of paragraph 7 describes, business profits do not include compensation received by an individual for the performance of personal services, whether as an employee or in an independent capacity. Thus, a consulting firm resident in one State whose employees perform services in the other State through a permanent establishment may be taxed in that other State on a net basis under Article 7. The salaries of the employees, however, will be subject to the rules of Article 15 (Dependent Personal Services). 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 22 (Other Income). Unlike the U.S. Model and the OECD Model, income derived by an enterprise from the rental of tangible personal property is not included in this Article, but instead (with the exception of container leasing which is included in Article 22 (Other Income) and ship and aircraft leasing covered by Article 8 ( Shipping and Air Transport)) is included in Article 12 (Royalties). . Paragraph 8Paragraph 8 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 4 of Article 10, the dividend is attributable to a permanent establishment or fixed base. In the latter case the provisions of Articles 7 or 14 (Independent Personal Services) 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's full corporate tax rate, rather than on a gross basis under Article 10 (Dividends). 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 9Paragraph 9 incorporates into the Convention the rule of Code section 864(c)(6). Like the Code section on which it is based, paragraph 8 provides that any income or gain attributable to a permanent establishment or a fixed base during its existence is taxable in the Contracting State where the permanent establishment or fixed base is situated, even if the payment of that income or gain is deferred until after the permanent establishment or fixed base ceases to exist. This rule applies with respect to paragraphs 1 and 2 of Article 7 (Business Profits), paragraph 6 of Article 10 (Dividends), paragraph 5 of Articles 11 (Interest), paragraph 4 of 12 (Royalties), paragraph 3 of Article 13 (Gains), Article 14 (Independent Personal Services) and paragraph 2 of Article 22 (Other Income). The effect of this rule can be illustrated by the following example. Assume a company that is a resident of the other Contracting State and that maintains a permanent establishment in the United States winds up the permanent establishment's business and sells the permanent establishment's inventory and assets to a U.S. buyer at the end of year 1 in exchange for an interest-bearing installment obligation payable in full at the end of year 3. Despite the fact that Article 13's threshold requirement for U.S. taxation is not met in year 3 because the company has no permanent establishment in the United States, the United States may tax the deferred income payment recognized by the company in year 3. Relation to Other ArticlesThis 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 Lithuania 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 3 of Article 24 (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 23 (Limitation on Benefits). Thus, an enterprise of Lithuania 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 23. |
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