[Senate Executive Report 110-16]
[From the U.S. Government Publishing Office]



110th Congress                                              Exec. Rept.
                                 SENATE
 2d Session                                                      110-16

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



 
               TAX CONVENTION AND PROTOCOL WITH BULGARIA

                                _______
                                

               September 11, 2008.--Ordered to be printed

                                _______
                                

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

                                 REPORT

                   [To accompany Treaty Doc. 110-18]

    The Committee on Foreign Relations, to which was referred 
the Convention between the Government of the United States of 
America and the Government of the Republic of Bulgaria for the 
Avoidance of Double Taxation and the Prevention of Fiscal 
Evasion with Respect to Taxes on Income, with accompanying 
Protocol, signed at Washington on February 23, 2007, as well as 
the Protocol Amending the Convention between the Government of 
the United States of America and the Government of the Republic 
of Bulgaria for the Avoidance of Double Taxation and the 
Prevention of Fiscal Evasion with Respect to Taxes on Income, 
signed at Sofia on February 26, 2008 (Treaty Doc. 110-18), 
having considered the same, reports favorably thereon with one 
declaration, as indicated in the resolution of advice and 
consent, and recommends that the Senate give its advice and 
consent to ratification thereof, as set forth in this report 
and the accompanying resolution of advice and consent.

                                CONTENTS

                                                                   Page

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

 IX. Annex I.--Technical Explanation..................................9
  X. Annex II.--Responses to Additional Questions Submitted for the 
     Record.........................................................107

                               I. Purpose

    The Convention, as amended by the 2008 Protocol, would 
promote and facilitate trade and investment between the United 
States and Bulgaria. In particular, the Convention is designed 
principally to reduce tax barriers to cross-border investment, 
provide for better exchange of tax information, and facilitate 
cross-border tax administration more generally.

                             II. Background

    The Convention, the first income tax treaty concluded 
between the United States and Bulgaria, was signed on February 
23, 2007. Before transmitting the Convention to the Senate, 
however, the executive branch concluded a Protocol to amend the 
Convention, which was signed just over a year later on February 
26, 2008. The 2008 Protocol essentially contains technical 
corrections to the 2007 Convention that would, as explained by 
the Treasury Department, ``address features of the Bulgarian 
tax system and treaty network that could result in a Bulgarian 
tax exemption for U.S. source income attributable to offshore 
branches of the Bulgarian company receiving the U.S. source 
income.'' The 2008 Protocol would amend the Convention to 
address this potential and unintended ``double exemption.'' 
With some notable exceptions discussed below, the Convention, 
as amended by the 2008 Protocol, is generally consistent with 
the 2006 U.S. Model Tax Treaty and with tax treaties that the 
United States has with other countries.

                         III. Major Provisions

    A detailed, article-by-article analysis of the Convention 
may be found in the Technical Explanation published by the 
Department of the Treasury on July 10, 2008, which is reprinted 
in Annex I. In addition, the staff of the Joint Committee on 
Taxation prepared an analysis of the Convention, Document JCX-
59-08 (July 8, 2008), which was of great assistance to the 
committee in reviewing the Convention. A summary of the key 
provisions of the Convention is set forth below.

1. Dividends

    Under the Convention, withholding taxes on cross-border 
portfolio dividend payments may be imposed at a maximum rate of 
10 percent. See Article 10(2)(b). When the beneficial owner of 
a cross-border dividend is a company that directly owns at 
least 10 percent of the stock of the company paying the 
dividend, a withholding tax may be imposed at a maximum rate of 
five percent. See Article 10(2)(a). No withholding tax, 
however, is permitted on dividends paid by a company resident 
in one of the countries to a pension fund that is a resident in 
the other country provided the dividend is not derived from the 
carrying on of a trade or business by such pension fund. See 
Article 10(4).

2. Royalties and Interest

    Under the Convention, withholding taxes on cross-border 
royalty payments would be imposed at a maximum rate of five 
percent. See Article 12(2). Similarly, withholding taxes on 
cross-border interest payments may be imposed at a maximum rate 
of five percent. See Article 11(2). No withholding tax on a 
cross-border interest payment is generally permitted, however, 
when the interest is beneficially owned by the government of 
the other country (or by a central bank or other institution 
wholly owned by that government); a resident of the other 
country with respect to debt-claims guaranteed, insured or 
indirectly financed by the government of the other country (or 
an institution controlled by that government); a pension fund 
resident in the other country, provided the interest is not 
derived from the carrying on of a trade or business by such 
pension fund; or, with some exceptions, a financial institution 
(including a bank or insurance company) resident in the other 
country. See Article 11(3).
    Under the 2007 Protocol signed on the same day as the 
Convention, the United States and Bulgaria are to reconsider 
source-country taxation of interest and royalties arising in 
Bulgaria and beneficially owned by a resident of the United 
States, at a time that is ``consistent with the conclusion of 
the transition period'' under a European Union Council 
Directive (``EU Directive'') applicable to interest and 
royalties deemed to arise in Bulgaria and beneficially owned by 
a resident of the European Union, which is due to occur on 
December 31, 2014. See Paragraph 7 of the 2007 Protocol.
    In response to Committee questions regarding this 
commitment to consult, the Treasury Department indicated that:


          At the conclusion of the transition period under the [EU 
        Directive], Bulgaria is expected to adopt rates of withholding 
        on cross-border interest and royalties for residents of 
        European Union member states that are lower than the rate 
        provided for in the proposed treaty. The provision of the 2007 
        Protocol is intended to memorialize the understanding between 
        Bulgaria and the United States that the United States will have 
        the opportunity at the conclusion of the transition period to 
        negotiate a further protocol to the proposed treaty with 
        Bulgaria that could reduce the maximum rate of withholding that 
        may be imposed on cross-border interest and royalties arising 
        in Bulgaria.

3. Permanent Establishment

    In general, U.S. bilateral tax treaties attempt to ensure 
that a person or entity is not subject to undue and overly 
burdensome taxation in instances in which the taxpayer has 
minimal contacts with the taxing jurisdiction. This is 
accomplished in the Convention through provisions under which 
each country generally agrees not to tax business income 
derived from sources within that country by residents of the 
other country unless the business activities in the taxing 
country are substantial enough to constitute a permanent 
establishment. See Article 7(1). A permanent establishment is 
generally defined as ``a fixed place of business through which 
the business of an enterprise is wholly or partly carried on.'' 
See Article 5(1). Examples include a place of management, 
offices, branches, and factories. See Article 5(2).
    The Convention, however, includes a special rule that would 
effectively expand the definition of a permanent establishment 
in a way that would affect enterprises that provide services. 
Specifically, an enterprise of one country would be deemed to 
have a permanent establishment in the other country if either 
a) services are performed by an individual who is present in 
the other country for at least 183 days during any 12-month 
period and more than 50 percent of the enterprise's gross 
active business revenues during that time is income derived 
from those services, or (b) the services are provided in the 
other country for at least 183 days during any 12-month period 
with respect to the same or a connected project for customers 
who are residents of that country or who have a permanent 
establishment there for which the services are provided. See 
Article 5(8). Thus, an enterprise that met either of these 
criteria would be deemed to have a permanent establishment in 
the treaty partner country, even if it did not have a fixed 
place of business in that country, and attributable business 
profits would be subject to tax by that country.
    This special rule presents a number of administrative and 
compliance challenges. For example, a number of the terms used 
in this rule, such as what constitutes ``presence'' or a 
``connected project,'' are ambiguous and require further 
clarification. In addition, when combined with Article 14 of 
the Convention, further complexities arise. Article 14(1) of 
the Convention, with certain exceptions, sets forth a general 
rule that if an employee who is a resident of one treaty 
country (the ``residence country'') is working in the other 
treaty country (the ``employment country''), his or her 
salaries, wages, and other remuneration derived from the 
exercise of employment in that country may be taxed by that 
country (the employment country). Notwithstanding this general 
rule, Article 14(2) of the treaty provides that the 
remuneration derived by the employee from the exercise of 
employment in the employment country shall be taxed only by the 
residence country (and not the employment country) if: 1) the 
employee is present in the employment country for 183 days or 
less in any 12-month period commencing or ending in the taxable 
year concerned; 2) the remuneration is paid by, or on behalf 
of, an employer who is not a resident of the employment 
country; and 3) the remuneration is not ``borne'' by a 
permanent establishment that the employer has in the employment 
country. It is the final requirement, which states that the 
remuneration must not be ``borne'' by a permanent establishment 
that the employer has in the employment country, that interacts 
with the special rule in Article 5(8) in a potentially 
significant and negative way.
    In other words, the salaries, wages, and other remuneration 
derived by an employee performing services through a permanent 
establishment arising under Article 5(8) of the Treaty would be 
subject under Article 14 to being taxed by the employment 
country, even if the other requirements of the test in Article 
14(2) had been met. Thus, the interaction of these two 
provisions increases the complexities associated with the 
special rule. For example, such a scenario would mean that an 
employer and the relevant employees would need to fulfill 
several tax-related obligations, including obtaining tax 
identification numbers and providing for the withholding of 
income taxes and other taxes as appropriate that would cover 
the period beginning on the first day such services were 
performed by such employee during the affected year, despite 
the fact that they may not know whether the enterprise will be 
deemed to have a permanent establishment under the Treaty until 
perhaps 6 months into the relevant 12-month period, and will 
therefore be subject to various taxes, including employment 
taxes, by the services country reaching back to the beginning 
of the relevant 12-month period.
    Another aspect of the rule that would appear to be 
difficult to manage is that the 12-month period is not tied to 
a fiscal or calendar year. Also, it is necessary to determine 
whether customers in the source country are residents or have a 
permanent establishment in that country. Moreover, an 
enterprise with a deemed permanent establishment in another 
country that is not an actual fixed base is unlikely to have 
the infrastructure in that other country to do the things 
necessary to comply with the rules of this provision. For 
example, such an enterprise is unlikely to keep in the 
employment country a full set of financial records or records 
tracking employees' activities there.
     The committee asked the Treasury Department a number of 
questions regarding this provision in an attempt to gain 
greater insight and clarity into its operation. These questions 
and answers can be found in Annex II.

4. Limitation on Benefits

    Consistent with current U.S. treaty policy, the Convention 
includes a ``Limitation on Benefits'' provision, which is 
designed to avoid treaty-shopping by limiting the indirect use 
of a treaty's benefits by persons who were not intended to take 
advantage of those benefits. Among other things, this provision 
provides that a company resident in a treaty country whose 
shares are regularly traded on a recognized stock exchange may 
qualify for treaty benefits if the company satisfies one of two 
tests: either the company must be primarily traded on a 
recognized stock exchange in its country of residence or the 
company's primary place of management and control must be in 
its country of residence. See Article 21(2). This requirement 
is intended to ensure that there is an adequate connection to 
the company's claimed country of residence.

5. Exchange of Information

    The Convention provides for an exchange of information 
between the United States and Bulgaria, which will facilitate 
the enforcement of U.S. domestic tax rules. Specifically, the 
Convention would allow the United States to obtain information 
(including bank information) for its own tax purposes. See 
Article 25.

6. Fiscally Transparent Entities

    The 2006 U.S. Model Tax Treaty allows recipients of 
``income, gains, or profits'' through an entity that is 
fiscally transparent under the tax laws of the recipient's 
residence to enjoy the same treaty benefits on that income as 
they would have if the ``income, gains, or profits'' had been 
received by them directly. Fiscally-transparent entities (a 
subset of which are called ``disregarded entities'') are 
entities that act as a conduit, apportioning all income 
received to those holding an interest in the entity. There is 
no requirement that the income be currently distributed to the 
interest holder, only that it be apportioned to them for tax 
purposes. Common examples are partnerships and limited 
liability companies (LLCs) that do not choose to be taxed as 
corporations under the U.S. ``check the box'' provisions. The 
Convention provision is consistent with the 2006 U.S. Model Tax 
Treaty provision. See Article 1(6).

7. Pension and Pension Funds

    The Convention provides that pensions and other similar 
remuneration paid to a resident of one country may be taxed 
only by that country and only at such time and to the extent 
that a pension distribution is made. See Article 17. Moreover, 
the Convention would eliminate withholding tax on cross-border 
dividend payments to pension funds. See Article 10(4).

                 IV. Entry Into Force; Effective Dates

    The United States and Bulgaria shall notify each other 
through diplomatic channels when their respective requirements 
for the entry into force of this Convention have been 
satisfied. This Convention shall enter into force on the date 
of receipt of the later of these notifications.
    The provisions of the Convention shall have effect in both 
countries with respect to taxes withheld at source, on income 
paid or credited on or after the first day of January in the 
calendar year next following the year in which this Convention 
enters into force; and with respect to other taxes on income, 
for any taxable period beginning on or after the first day of 
January in the calendar year next following the year in which 
this Convention enters into force.

                      V. Implementing Legislation

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

                          VI. Committee Action

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

               VII. Committee Recommendation and Comments

    The Committee on Foreign Relations believes that the 
Convention, as amended by the 2008 Protocol, will stimulate 
increased trade and investment, substantially deny treaty-
shoppers the benefits of this tax treaty, and promote closer 
cooperation between the United States and Bulgaria. The 
committee therefore urges the Senate to act promptly to give 
advice and consent to ratification of the Convention and the 
2008 Protocol, as set forth in this report and the accompanying 
resolution of advice and consent.

          A. SPECIAL PERMANENT ESTABLISHMENT RULE FOR SERVICES

    As discussed in Section III, the Convention includes a 
special rule that would effectively expand the standard 
definition of a permanent establishment in a way that affects 
enterprises that provide services. This provision also appears 
in the Canada Tax Protocol currently under consideration and 
presents a number of serious administrative and compliance 
challenges to service enterprises that may be subject to the 
rule. The Treasury Department has made clear in testimony 
before the committee that the inclusion of this provision in 
the Convention and the Canada Tax Protocol ``does not reflect a 
change in U.S. tax treaty policy, and inclusion of such a 
provision in the U.S. Model is not being considered.'' The 
committee welcomes this statement and urges the Treasury 
Department to avoid including such a provision in future tax 
treaties.
    Although the United States has included similar provisions 
in some of its tax treaties with developing nations\1\ and a 
rationale exists for providing for expanded source taxation in 
treaties with developing countries that frequently rely on 
service providers from wealthier nations that do not 
necessarily have a fixed place of business in their country, 
the inherent difficulties in implementing this rule are 
substantial.
---------------------------------------------------------------------------
    \1\The United States has included similar provisions in the tax 
treaties with, for example, Indonesia (Treaty Doc. 100-22; Article 
5(2)), India (Treaty Doc. 101-5; Article 5(2)), and Thailand (Treaty 
Doc. 105-2; Article 5(3)).
---------------------------------------------------------------------------
    Finally, the committee urges the Treasury Department to 
engage in discussions not just with Canada, but also with 
Bulgaria, regarding the interpretation and application of the 
new rule concerning the taxation of services in an effort to 
improve its implementation. Upon completion of such 
discussions, the committee urges the Treasury Department to 
produce guidance on its application and ways in which 
enterprises might approach their compliance.

                             B. RESOLUTION

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

Declaration

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

         VIII. Resolution of Advice and Consent to Ratification


  TEXT OF RESOLUTION OF ADVICE AND CONSENT TO RATIFICATION OF THE TAX 
                 CONVENTION AND PROTOCOL WITH BULGARIA

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

SECTION 1. SENATE ADVICE AND CONSENT SUBJECT TO A DECLARATION

    The Senate advises and consents to the ratification of the 
Convention between the Government of the United States of 
America and the Government of the Republic of Bulgaria for the 
Avoidance of Double Taxation and the Prevention of Fiscal 
Evasion with Respect to Taxes on Income, with accompanying 
Protocol, signed at Washington on February 23, 2007, as well as 
the Protocol Amending the Convention between the Government of 
the United States of America and the Government of the Republic 
of Bulgaria for the Avoidance of Double Taxation and the 
Prevention of Fiscal Evasion with Respect to Taxes on Income, 
signed at Sofia on February 26, 2008 (Treaty Doc. 110-18), 
subject to the declaration of section 2.

SECTION 2. DECLARATION

    The advice and consent of the Senate under section 1 is 
subject to the following declaration:
    This Convention is self-executing.
                  IX. Annex I.--Technical Explanation


 TECHNICAL EXPLANATION OF THE CONVENTION BETWEEN THE UNITED STATES OF 
   AMERICA AND THE REPUBLIC OF BULGARIA FOR THE AVOIDANCE OF DOUBLE 
TAXATION AND THE PREVENTION OF FISCAL EVASION WITH RESPECT TO TAXES ON 
           INCOME, SIGNED AT WASHINGTON ON FEBRUARY 23, 2007

    This is a technical explanation of the Convention between 
the United States and Bulgaria for the Avoidance of Double 
Taxation and the Prevention of Fiscal Evasion with Respect to 
Taxes on Income, signed on February 23, 2007, and the Protocol 
between the United States and Bulgaria signed on the same date 
(the ``Protocol''), as amended by the Protocol between the 
United States and Bulgaria signed on February 26, 2008 
(collectively, the ``Convention''). The Protocol is discussed 
below in connection with the relevant articles of 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, updated as of 
November 15, 2006. 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. It reflects the policies behind particular 
Convention provisions, as well as understandings reached during 
the negotiations with respect to the application and 
interpretation of the Convention. 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 Bulgaria 
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 Bulgaria, 
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 State 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. A taxpayer may use the treaty 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 Bulgaria 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 Bulgaria. For example, if certain benefits are 
provided for military personnel or military contractors under a 
Status of Forces Agreement between the United States and 
Bulgaria, 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 the General 
Agreement on Trade in Services (the ``GATS''). The provisions 
of paragraph 3 are an exception to the rule provided in 
paragraph 2 of this Article under which the Convention shall 
not restrict in any manner any benefit now or hereafter 
accorded by any other agreement between the Contracting 
States.Subparagraph 3(a) provides that, unless the competent 
authorities determine that a taxation measure is not within the 
scope of the Convention, the national treatment obligations of 
the GATS shall not apply with respect to that measure. Further, 
any question arising as to the interpretation of the 
Convention, including in particular whether a measure is within 
the scope of the Convention shall be considered only by the 
competent authorities of the Contracting States, and the 
procedures under the Convention exclusively shall apply to the 
dispute. Thus, paragraph 3 of Article XXII (Consultation) of 
the GATS may not be used to bring a dispute before the World 
Trade Organization unless the competent authorities of both 
Contracting States have determined that the relevant taxation 
measure is not within the scope of Article 23 (Non-
Discrimination) of the Convention.
    The term ``taxation measure'' for these purposes is defined 
broadly in subparagraph 3(b). It would include, for example, a 
law, regulation, rule, procedure, decision, administrative 
action or guidance, or any other form of measure relating to 
taxation.

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 Bulgaria 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 Bulgaria is also a citizen of the United States, the saving 
clause permits the United States to include the remuneration in 
the worldwide income of the citizen and subject it to tax under 
the normal Code rules (i.e., without regard to Code section 8 
94(a)). However, subparagraph 5(a) of Article 1 preserves the 
benefits of special foreign tax credit rules applicable to the 
U.S. taxation of certain U.S. income of its citizens resident 
in Bulgaria. See paragraph 4 of Article 22 (Relief from Double 
Taxation).
    For purposes of the saving clause, ``residence'' is 
determined under Article 4 (Resident). 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 
Bulgaria 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 treaty.
    However, the person would be treated as a U.S. resident for 
U.S. tax purposes other than determining the individual's U.S. 
tax liability. For example, in determining under Code section 
957 whether a foreign corporation is a controlled foreign 
corporation, shares in that corporation held by the individual 
would be considered to be held by a U.S. resident. As a result, 
other U.S. citizens or residents might be deemed to be United 
States shareholders of a controlled foreign corporation subject 
to current inclusion of Subpart F income recognized by the 
corporation. See Treas. Reg. section 301.7701 (b)-7(a)(3).
    Under paragraph 4, the United States also reserves its 
right to tax former citizens and former long-term residents for 
a period of ten years following the loss of such status with 
respect to income from sources within the United States 
(including income deemed under the domestic law of the United 
States to arise from such sources). 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. Paragraph 1 of the Protocol provides 
that the term ``long-term resident'' means any individual who 
is a lawful permanent resident of the United States in eight or 
more taxable years during the preceding 15 taxable years. In 
determining whether the eight-year threshold is met, one does 
not count any year in which the individual is treated as a 
resident of Bulgaria under the Convention (or as a resident of 
any country other than the United States under the provisions 
of any other U.S. tax treaty), and the individual does not 
waive the benefits of such treaty applicable to residents of 
the other country. This understanding is consistent with how 
this provision is generally interpreted in U.S. tax treaties..

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 (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 5 of Article 17 (Pensions, 
        Social Security Payments, Annuities, Alimony, and Child 
        Support) provide exemptions from source or residence 
        State taxation for certain pension distributions and 
        social security payments.

          (3) Article 22 (Relief from Double Taxation) confirms 
        to citizens and residents of one Contracting State the 
        benefit of a credit for income taxes paid to the other 
        or an exemption for income earned in the other State.

          (4) Article 23 (Non-Discrimination) protects 
        residents and nationals of one Contracting State 
        against the adoption of certain discriminatory 
        practices in the other Contracting State.

          (5) Article 24 (Mutual Agreement Procedure) confers 
        certain benefits on citizens and residents of the 
        Contracting States in order to reach and implement 
        solutions to disputes between the two Contracting 
        States. For example, the competent authorities are 
        permitted to use a definition of a term that differs 
        from an internal law definition. The statute of 
        limitations may be waived for refunds, so that the 
        benefits of an agreement may be implemented.


    Subparagraph 5(b) provides a different set of exceptions to 
the saving clause. The benefits referred to are all intended to 
be granted to temporary residents of a Contracting State (for 
example, in the case of the United States, holders of non-
immigrant visas), but not to citizens or to persons who have 
acquired permanent residence in that State. If beneficiaries of 
these provisions travel from one of the Contracting States to 
the other, and remain in the other long enough to become 
residents under its internal law, but do not acquire permanent 
residence status (i.e., in the U.S. context, they do not become 
``green card'' holders) and are not citizens of that State, the 
host State will continue to grant these benefits even if they 
conflict with the statutory rules. The benefits preserved by 
this paragraph are: (1) the host country exemptions for 
government service salaries and pensions under Article 18 
(Government Service), certain income of visiting students, 
trainees, teachers, and researchers under Article 19 (Students, 
Trainees, Teachers and Researchers), and the income of 
diplomatic agents and consular officers under Article 26 
(Members of Diplomatic Missions and Consular Posts).

Paragraph 6

    Paragraph 6 addresses special issues presented by fiscally 
transparent entities such as partnerships and certain estates 
and trusts. Because different countries frequently take 
different views as to when an entity is fiscally transparent, 
the risk of both double taxation and double non-taxation are 
relatively high. The intention of paragraph 6 is to eliminate a 
number of technical problems that arguably would have prevented 
investors using such entities from claiming treaty benefits, 
even though such investors would be subject to tax on the 
income derived through such entities. The provision also 
prevents the use of such entities to claim treaty benefits in 
circumstances where the person investing through such an entity 
is not subject to tax on the income in its State of residence. 
The provision, and the corresponding requirements of the 
substantive rules of Articles 6 through 20, should be read with 
those two goals in mind.
    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 
relieved under an integrated system. 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. 
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'') that are treated as 
partnerships or as disregarded entities for U.S. tax purposes.
    Under paragraph 6, an item of income derived by such a 
fiscally transparent entity will be considered to be derived by 
a resident of a Contracting State if a resident is treated 
under the taxation laws of that State as deriving the item of 
income. For example, if a company that is a resident of 
Bulgaria pays interest to an entity that is treated as fiscally 
transparent for U.S. tax purposes, the interest will be 
considered derived by a resident of the United States only to 
the extent that the taxation laws of the United States treats 
one or more U.S. residents (whose status as U.S. residents is 
determined, for this purpose, under U.S. tax law) as deriving 
the interest 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 interest income 
through the partnership. Also, it 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 for the interest 
paid to the entity under the Convention, because they are not 
residents of the United States for purposes of claiming this 
treaty benefit. (If, however, the country in which they are 
treated as resident for tax purposes, as determined under the 
laws of that country, has an income tax convention with 
Bulgaria, they may be entitled to claim a benefit under that 
convention.) In contrast, if, for example, an entity is 
organized under U.S. laws and is classified as a corporation 
for U.S. tax purposes, interest paid by a company that is a 
resident of Bulgaria 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.
    The same result obtains even if the entity were viewed 
differently under the tax laws of Bulgaria (e.g., as not 
fiscally transparent in the first example above where the 
entity is treated as a partnership for U.S. tax purposes). 
Similarly, the characterization of the entity in a third 
country is also irrelevant, even if the entity is organized in 
that third country. The results follow regardless of whether 
the entity is disregarded as a separate entity under the laws 
of one jurisdiction but not the other, such as a single owner 
entity that is viewed as a branch for U.S. tax purposes and as 
a corporation for tax purposes under the laws of Bulgaria. 
These results also obtain regardless of where the entity is 
organized (i.e., in the United States, in Bulgaria or, as noted 
above, in a third country).
    For example, income from U.S. sources received by an entity 
organized under the laws of the United States, which is treated 
for tax purposes under the laws of Bulgaria as a corporation 
and is owned by a shareholder who is a resident of Bulgaria for 
its tax purposes, is not considered derived by the shareholder 
of that corporation even if, under the tax laws of the United 
States, the entity is treated as fiscally transparent. Rather, 
for purposes of the treaty, the income is treated as derived by 
the U.S. entity.
    These principles also apply to trusts to the extent that 
they are fiscally transparent in either Contracting State. For 
example, if X, a resident of Bulgaria, creates a revocable 
trust in the United States and names persons resident in a 
third country as the beneficiaries of the trust, the trust's 
income would be regarded as being derived by a resident of 
Bulgaria only to the extent that the laws of Bulgaria treat X 
as deriving the income for its tax purposes, perhaps through 
application of rules similar to the U.S. ``grantor trust'' 
rules.
    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 tax law. For example, if a 
U.S. LLC with members who are residents of Bulgaria 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 Bulgaria views the LLC as 
fiscally transparent.

                       ARTICLE 2 (TAXES COVERED)

    This Article specifies the U.S. taxes and the taxes of 
Bulgaria 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, 
however, for purposes of Articles 23 (Non-Discrimination) and 
25 (Exchange of Information and Administrative Assistance). 
Article 23 (Non-Discrimination) applies with respect to all 
taxes, including those imposed by state and local governments. 
Article 25 (Exchange of Information and Administrative 
Assistance) 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 (Non-Discrimination), 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 and on capital gains. 
The Convention covers taxes on total income or any part of 
income and includes tax on gains derived from the alienation of 
property. The Convention does not apply, however, to social 
security charges, or any other charges where there is a direct 
connection between the levy and individual benefits. Nor does 
it apply to property taxes, except with respect to Article 23 
(Non-Discrimination).

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 Bulgaria are identified in 
subparagraph 3(a), as the personal income tax and the corporate 
income tax. Paragraph 2 of the Protocol clarifies that these 
taxes include the patent tax, which is a tax imposed on certain 
small business operations in lieu of a net basis income 
tax.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 the investment income of foreign 
private foundations (Code section 4940). Social security and 
unemployment taxes (Code sections 1401, 3101, 3111 and 3301) 
are excluded from coverage.

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 February 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 changes that have been 
made in their laws, whether tax laws or non-tax laws, that 
significantly affect 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 Convention in 
order to avoid results not intended by the Convention's 
negotiators.
    The geographical scope of the Convention with respect to 
Bulgaria is set out in subparagraph 1(a). The term ``Bulgaria'' 
encompasses the Republic of Bulgaria, including the territory 
and the territorial sea over which it exercises its State 
sovereignty, as well as the continental shelf and the exclusive 
economic zone over which it exercises sovereign rights and 
jurisdiction in conformity with international law.
    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 activityinvolving 
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 Code section 638, which treats the 
continental shelf as part of the United States for purposes of 
natural resource exploration and exploitation.
    Subparagraph 1(c) provides that the terms ``a Contracting 
State'' and ``the other Contracting State'' shall mean Bulgaria 
or the United States, as the context requires.
    Subparagraph 1(d) defines the term ``person'' to include an 
individual, a company and any other body of persons. Paragraph 
3 of the Protocol clarifies that the term ``any other body of 
persons'' includes partnerships, trusts, and estates. 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 
Convention. Also, all ``persons'' are eligible to claim relief 
under Article 24 (Mutual Agreement Procedure).
    The term ``company'' is defined in subparagraph 1(e) 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.
    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 Bulgaria would 
still be a U.S. enterprise).
    These terms also encompass an enterprise conducted through 
an entity (such as a partnership) that is treated as fiscally 
transparent in the Contracting State where the entity's owner 
is resident. In accordance with Article 4 (Resident), entities 
that are fiscally transparent in the Contracting State in which 
their owners are resident are not considered to be residents of 
that Contracting 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 (g) 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 (h) 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). Subparagraph (i) further clarifies, at the 
request of Bulgaria, that ``business profits'' also include 
income from the performance of professional services and other 
activities of an independent character.
    Subparagraph 1 (j) 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. 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 (International Traffic), therefore, would not apply 
to income from such carriage. Thus, if the carrier engaged in 
internal U.S. traffic were a resident of Bulgaria (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 Bulgaria from a non-U.S. port to, for example, New York, and 
some of the goods or passengers continue on to Chicago, the 
entire transport would be international traffic. This would be 
true if the international carrier transferred the goods at the 
U.S. port of entry from a ship to a land vehicle, from a ship 
to a lighter, or even if the overland portion of the trip in 
the United States was handled by an independent carrier under 
contract with the original internation*al carrier, so long as 
both parts of the trip were reflected in original bills of 
lading. For this reason, the Convention, following the U.S. 
Model refers, in the definition of ``international traffic,'' 
to ``such transport'' being solely between places in the other 
Contracting State, while the OECD Model refers to the ship or 
aircraft being operated solely between such places. The 
formulation in the Convention is intended to make clear that, 
as in the above example, even if the goods are carried on a 
different aircraft for the internal portion of the 
international voyage than is used for the overseas portion of 
the trip, the definition applies to that internal portion as 
well as the external portion.
    Finally, a ``cruise to nowhere,'' i.e., a cruise beginning 
and ending in a port in the same Contracting State with no 
stops in a foreign port, would not constitute international 
traffic.
    Subparagraph 1(k) designates the ``competent authorities'' 
for Bulgaria and the United States. The Bulgarian competent 
authority is the Minister of Finance or an authorized 
representative. The U.S. competent authority is the Secretary 
of the Treasury or his delegate. The Secretary of the Treasury 
has delegated the competent authority function to the 
Commissioner of Internal Revenue, who in turn has delegated the 
authority to the Deputy Commissioner (International) LMSB. With 
respect to interpretative issues, the Deputy Commissioner 
(International) LMSB acts with the concurrence of the Associate 
Chief Counsel (International) of the Internal Revenue Service.
    The term ``national,'' as it relates to the United States 
and to Bulgaria, is defined in subparagraph 1(l). 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 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(m) defines the term ``pension fund'' to 
include any person 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. In the case of the United States, the 
term ``pension fund'' 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 
trust providing pension or retirement benefits under 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 Rev. Rul. 
81-100, 1981-1 C.B. 326, and meeting the conditions of Rev. 
Rul. 2004-67, 2204-2 C.B. 28, qualify as pension funds because 
they are covered by Code section 401(a).

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 paragraph 3(f) of 
Article 24 (Mutual Agreement Procedure), may establish a common 
meaning in order to prevent double taxation or to further any 
other purpose of the Convention. This common meaning need not 
conform to the meaning of the term under the laws of either 
Contracting State.
    The reference in paragraph 2 to the internal law of a 
Contracting State means the law in effect at the time the 
Convention is being applied, not the law as in effect at the 
time the Convention 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 Convention was negotiated and ratified. The 
reference in both paragraphs 1 and 2 to the ``context otherwise 
requir[ing]'' a definition different from the Convention 
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 Bulgaria by 
referring to a resident as a person who, under the laws of a 
Contracting State, is subject to tax there by reason of his 
domicile, residence, citizenship, place of management, place of 
incorporation or any other similar criterion. Thus, residents 
of the United States include aliens who are considered U.S. 
residents under Code section 7701(b). Paragraph 1 also 
specifically includes the two Contracting States, and political 
subdivisions and local authorities of the two States, as 
residents for purposes of the Convention.
    Certain entities that are nominally subject to tax but that 
in practice are rarely required to pay tax also would generally 
be treated as residents and therefore accorded treaty benefits. 
For example, a U.S. Regulated Investment Company (RIC) and a 
U.S. Real Estate Investment Trust (REIT) are residents of the 
United States for purposes of the treaty. Although the income 
earned by these entities normally is not subject to U.S. tax in 
the hands of the entity, they are taxable to the extent that 
they do not currently distribute their profits, and therefore 
may be regarded as ``liable to tax.'' They also must satisfy a 
number of requirements under the Code in order to be entitled 
to special tax treatment.
    Under paragraph 1 of the Convention and paragraph 4 of the 
Protocol, a person who is liable to tax in a Contracting State 
only in respect of income from sources within that State 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 
Bulgaria 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 Bulgaria 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 4 of the Protocol also clarifies that if a 
company is a resident of one of the Contracting States under 
the domestic law of that State, but is treated as a resident of 
a third state under a treaty between that State and the third 
state, then it will not be treated as a resident of the 
Contracting State for purposes of the Convention. For example, 
if a company that is organized in Bulgaria is managed and 
controlled in the United Kingdom, both countries would treat 
the company as being a resident under its domestic laws. 
However, if a treaty between Bulgaria and the United Kingdom 
assigned residence in such a case to the country in which the 
company's place of effective management is located, and the 
place of effective management is the United Kingdom, the 
company would not qualify for benefits under the U.S.-Bulgaria 
treaty because it is not subject to tax in Bulgaria as a 
resident of Bulgaria. This rule is consistent with the holding 
of Rev. Rul. 2004-76, 2004-2 C.B. 111.

Paragraph 2

    Paragraph 2 provides that certain tax-exempt entities such 
as pension funds 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 paragraph applies to legal persons organized 
under the laws of a Contracting State and established and 
maintained in that State to provide pensions or other similar 
benefits pursuant to a plan, or exclusively for religious, 
charitable, scientific, artistic, cultural, or educational 
purposes. Thus, a section 501(c) organization organized in the 
United States (such as a U.S. charity) that is generally exempt 
from tax under U.S. law is a resident of the United States for 
all purposes of the Convention.

Paragraph 3

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

Paragraph 4

    Dual residents other than individuals (such as companies, 
trusts, or estates) are addressed by paragraph 4. If such a 
person is, under the rules of paragraph 1 or 2, 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 dual 
resident may not claim any benefit accorded to residents of a 
Contracting State by the Convention. The dual resident may, 
however, claim any benefits that are not limited to residents, 
such as those provided by paragraph 1 of Article 23 (Non-
Discrimination). Thus, for example, a State cannot discriminate 
against a dual resident company.
    Dual residents also 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 Bulgaria, 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 Bulgaria, 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 
residents 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, 11 
and 12 (dealing with dividends, interest, and royalties, 
respectively) provide for reduced rates of tax at source on 
payments of these items of income to a resident of the other 
State only when the income is not attributable to a permanent 
establishment that the recipient has in the source State. The 
concept is also relevant in determining which Contracting State 
may tax certain gains under Article 13 (Capital Gains) and 
certain ``other income'' under Article 20 (Other Income).

Paragraph 1

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

Paragraph 2

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

Paragraph 3

    This paragraph provides rules to determine whether a 
building site or a construction, assembly or installation 
project, or an installation or drilling rig or ship used for 
the exploration of natural resources constitutes a permanent 
establishment for the contractor, driller, etc. Such a site or 
activity does not create a permanent establishment unless the 
site, project, etc. lasts, or the exploration activity 
continues, for more than six 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 (f) of 
paragraph 2. Thus, a drilling rig does not constitute a 
permanent establishment if a well is drilled in only three 
months, but if production begins in the following month the 
well becomes a permanent establishment as of that date.
    The six-month test applies separately to each site or 
project. The six-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 six-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 six months. If a sub-contractor is on a site 
intermittently, then, for purposes of applying the six-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 six-month threshold is exceeded, the site or project 
constitutes a permanent establishment from the first day of 
activity.

Paragraph 4

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

Paragraph 5

    Paragraphs 5 and 6 specify when activities carried on by an 
agent or other person acting on behalf of an enterprise create 
a permanent establishment of that enterprise. For example, 
under subparagraph 5(a), 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 that enterprise. If, however, 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 that enterprise'' rather than the US 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 
of the Article 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.
    Under subparagraph 5(b), a person is also deemed to create 
a permanent establishment of the enterprise if that person has 
no authority to conclude contracts, but habitually maintains in 
that State a stock of goods or merchandise belonging to the 
enterprise from which the person regularly fills orders or 
makes deliveries on behalf of the enterprise, and additional 
activities conducted in that State on behalf of the enterprise 
have contributed to the conclusion of the sale of such goods or 
merchandise.

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

Paragraph 7

    This paragraph clarifies that a company that is a resident 
of a Contracting State is not deemed to have a permanent 
establishment in the other Contracting State merely because it 
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.

Paragraph 8

    Paragraph 8 provides a special rule (subject to the 
provisions of paragraph 4) for an enterprise of a Contracting 
State that provides services in the other Contracting State, 
but that does not have a permanent establishment by virtue of 
the preceding paragraphs of the Article. If (and only if) such 
an enterprise meets either of two tests as provided in 
subparagraphs 8(a) and 8(b), the enterprise will be deemed to 
provide those services through a permanent establishment in the 
other State.
    The first test as provided in subparagraph 8(a) has two 
parts. First, the services must be performed in the other State 
by an individual who is present in that other State for a 
period or periods aggregating 183 days or more in any twelve-
month period. Second, during that period or periods, more than 
50 percent of the gross active business revenues of the 
enterprise (including revenue from active business activities 
unrelated to the provision of services) must consist of income 
derived from the services performed in that State by that 
individual. If the enterprise meets both of these tests, the 
enterprise will be deemed to provide the services through a 
permanent establishment. This test in subparagraph 8(a) is 
employed to determine whether an enterprise is deemed to have a 
permanent establishment by virtue of the presence of a single 
individual (i.e. a natural person).
    For the purposes of subparagraph 8(a), the term ``gross 
active business revenues'' shall mean the gross revenues 
attributable to active business activities that the enterprise 
has charged or should charge for its active business 
activities, regardless of when the actual billing will occur or 
of domestic law rules concerning when such revenues should be 
taken into account for tax purposes. Such active business 
activities are not restricted to the activities related to the 
provision of services. However, the term does not include 
income from passive investment activities.
    The second test as provided in subparagraph 8(b) provides 
that an enterprise will have a permanent establishment if the 
services are provided in the other State for an aggregate of 
183 days or more in any twelve-month period with respect to the 
same or connected projects for customers who either are 
residents of the other State or maintain a permanent 
establishment in the other State with respect to which the 
services are provided. The various conditions that have to be 
satisfied in order for subparagraph 8(b) to have application 
are described in detail below.
    In addition to meeting the 183-day threshold, the services 
must be provided for customers who either are residents of the 
other State or maintain a permanent establishment in that 
State. The intent of this requirement is to reinforce the 
concept that unless there is a customer in the other State, 
such enterprise will not be deemed as participating 
sufficiently in the economic life of that other State to 
warrant being deemed to have a permanent establishment.
    Paragraph 8 applies only to the provision of services, and 
only to services provided by an enterprise to third parties. 
Thus, the provision does not have the effect of deeming an 
enterprise to have a permanent establishment merely because 
services are provided to that enterprise.
    Further, paragraph 8 only applies to services that are 
performed or provided by an enterprise of a Contracting State 
within the other Contracting State. It is therefore not 
sufficient that the relevant services be merely furnished to a 
resident of the other Contracting State. Where, for example, an 
enterprise provides customer support or other services by 
telephone or computer to customers located in the other State, 
those would not be covered by paragraph 8 because they are not 
performed or provided by that enterprise within the other 
State. Another example would be that of an architect who is 
hired to design blueprints for the construction of a building 
in the other State. As part of completing the project, the 
architect must make site visits to that other State, and his 
days of presence there would be counted for purposes of 
determining whether the 183-day threshold is satisfied. 
However, the days that the architect spends working on the 
blueprint in his home office shall not count for purposes of 
the 183-day threshold, because the architect is not performing 
or providing those services within the other State.
    For purposes of determining whether the time threshold has 
been met, subparagraph 8(b) permits the aggregation of services 
that are provided with respect to connected projects. For 
purposes of this test, projects shall be considered to be 
connected if they constitute a coherent whole, commercially and 
geographically. The determination of whether projects are 
connected should be determined from the point of view of the 
enterprise (not that of the customer), and will depend on the 
facts and circumstances of each case. In determining the 
existence of commercial coherence, factors that would be 
relevant include: 1) whether the projects would, in the absence 
of tax planning considerations, have been concluded pursuant to 
a single contract; 2) whether the nature of the work involved 
under different projects is the same; and 3) whether the same 
individuals are providing the services under the different 
projects. Whether the work provided is covered by one or 
multiple contracts may be relevant, but is not determinative, 
in finding that projects are commercially coherent.
    The aggregation rule addresses, for example, potentially 
abusive situations in which work has been artificially divided 
into separate components in order to avoid meeting the 183-day 
threshold. Assume for example, that a technology consultant has 
been hired to install a new computer system for a company in 
the other country. The work will take ten months to complete. 
However, the consultant purports to divide the work into two 
five-month projects with the intention of circumventing the 
rule in paragraph 8. In such case, even if the two projects 
were considered separate, they will be considered to be 
commercially coherent. Accordingly, subject to the additional 
requirement of geographic coherence, the two projects could be 
considered to be connected, and could therefore be aggregated 
for purposes of subparagraph 8(b). In contrast, assume that the 
technology consultant is contracted to install a particular 
computer system for a company, and is also hired by that same 
company, pursuant to a separate contract, to train its 
employees on the use of another computer software that is 
unrelated to the first system. In this second case, even though 
the contracts are both concluded between the same two parties, 
there is no commercial coherence to the two projects, and the 
time spent fulfilling the two contracts may not be aggregated 
for purposes of subparagraph 8(b). Another example of projects 
that do not have commercial coherence would be the case of a 
law firm which, as one project provides tax advice to a 
customer from one portion of its staff, and as another project 
provides trade advice from another portion of its staff, both 
to the same customer.
    Additionally, projects, in order to be considered 
connected, must also constitute a geographic whole. An example 
of projects that lack geographic coherence would be a case in 
which a consultant is hired to execute separate auditing 
projects at different branches of a bank located in different 
cities pursuant to a single contract. In such an example, while 
the consultant's projects are commercially coherent, they are 
not geographically coherent and accordingly the services 
provided in the various branches shall not be aggregated for 
purposes of applying subparagraph 8(b). The services provided 
in each branch should be considered separately for purposes of 
subparagraph 8(b).
    The method of counting days for purposes of subparagraph 
8(a) differs slightly from the method for subparagraph 8(b). 
Subparagraph 8(a) refers to days in which an individual is 
present in the other country. Accordingly, physical presence 
during a day is sufficient. In contrast, subparagraph 8(b) 
refers to days during which services are provided by the 
enterprise in the other country. Accordingly, non-working days 
such as weekends or holidays would not count for purposes of 
subparagraph 8(b), as long as no services are actually being 
provided while in the other country on those days. For the 
purposes of both subparagraphs, even if the enterprise sends 
many individuals simultaneously to the other country to provide 
services, their collective presence during one calendar day 
will count for only one day of the enterprise's presence in the 
other country. For instance, if an enterprise sends 20 
employees to the other country to provide services to a client 
in the other country for 10 days, the enterprise will be 
considered present in the other country only for 10 days, not 
200 days (20 employees x 10 days).
    By deeming the enterprise to provide services through a 
permanent establishment in the other Contracting State, 
paragraph 8 allows the application of Article 7 (Business 
Profits), and accordingly, the taxation of the services shall 
be on a net-basis. Such taxation is also limited to the profits 
attributable to the activities carried on in performing the 
relevant services. It will be important to ensure that only the 
profits properly attributable to the functions performed and 
risks assumed by provision of the services will be attributed 
to the deemed permanent establishment.
    Paragraph 8 applies subject to the provisions of paragraph 
4. In no case will paragraph 8 apply to deem services to be 
provided through a permanent establishment if the services are 
limited to those mentioned in paragraph 4 which, if performed 
through a fixed place of business, would not make the fixed 
place of business a permanent establishment under the 
provisions of that paragraph. Further, days spent on 
preparatory or auxiliary activities shall not be taken into 
account for purposes of applying subparagraph 8(b).

       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. However, until such time 
as Bulgaria provides, with respect to income taxable under this 
Article, for an election to be subject to tax on a net basis as 
though such income were business profits attributable to a 
permanent establishment, the Bulgarian rate of tax may not 
exceed 10 percent of the gross amount of income derived by a 
U.S. resident from real property situated in Bulgaria.

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

Paragraph 3

    Paragraph 3 makes clear that all forms of income derived 
from the exploitation of real property are taxable in the 
Contracting State in which the property is situated. This 
includes income from any use of real property, including, but 
not limited to, income from direct use by the owner (in which 
case income may be imputed to the owner for tax purposes) and 
rental income from the letting of real property.
    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 (Capital Gains). 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 
(Capital Gains) 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 Article 7 (Business Profits) that income 
must be attributable to a permanent establishment in order to 
be taxable in the situs state. However, if a resident of a 
Contracting State carries on a business in the other 
Contracting State through a permanent establishment situated 
therein and the real property is effectively connected with 
such permanent establishment, the provisions of Article 7 apply 
to the real property income. This rule is important in view of 
the lack of an election to be subject to tax on a net basis 
with respect to income taxable under this Article under 
Bulgarian law and the Convention. Accordingly, if a U.S. 
resident has a permanent establishment in Bulgaria through 
which the real property income is earned, that income will be 
taxed on a net basis using the rates and rules of taxation 
generally applicable to residents of Bulgaria, as such rules 
may be modified by the Convention.

Paragraph 5

    This paragraph contains a special rule limiting the rate of 
Bulgarian taxation to 10 percent of the gross amount of income 
derived by a U.S. resident from real property situated in 
Bulgaria. This special rule applies for as long as U.S. 
residents are not entitled under Bulgarian law to make an 
election to compute the tax on income from real property 
situated in Bulgaria on a net basis as if such income were 
business profits attributable to a permanent establishment in 
Bulgaria.

                      ARTICLE 7 (BUSINESS PROFITS)

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

Paragraph 1

    Paragraph 1 states the general rule that business profits 
of an enterprise of one Contracting State may not be taxed by 
the other Contracting State unless the enterprise carries on 
business in that other Contracting State through a permanent 
establishment (as defined in Article 5 (Permanent 
Establishment)) situated there. When that condition is met, the 
State in which the permanent establishment is situated may tax 
the enterprise on the income that is attributable to the 
permanent establishment.
    Although the Convention does not include a definition of 
``business profits,'' the term is intended to cover income 
derived from any trade or business. In accordance with this 
broad definition, the term ``business profits'' includes income 
attributable to notional principal contracts and other 
financial instruments to the extent that the income is 
attributable to a trade or business of dealing in such 
instruments or is otherwise related to a trade or business (as 
in the case of a notional principal contract entered into for 
the purpose of hedging currency risk arising from an active 
trade or business). Any other income derived from such 
instruments is, unless specifically covered in another article, 
dealt with under Article 20 (Other Income).
    The term ``business profits'' also includes income derived 
by an enterprise from the rental of tangible personal property 
(unless such tangible personal property consists of aircraft, 
ships or containers, income from which is addressed by Article 
8 (International Traffic)). 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 (Other Income).
    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 that 
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 Bulgaria 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 Bulgaria 
may be taxed in the United States in respect of their share of 
the income attributable to the permanent establishment, Office 
B. The services giving rise to income which may be attributed 
to the permanent establishment would include not only the 
services performed by the one resident partner, but also, for 
example, if one of the four other partners came to the United 
States and worked on an Office B matter there, the income in 
respect of those services. Income from the services performed 
by the visiting partner would be subject to tax in the United 
States regardless of whether the visiting partner actually 
visited or used Office B while performing services in the 
United States.

Paragraph 2

    Paragraph 2 provides rules for the attribution of business 
profits to a permanent establishment. The Contracting States 
will attribute to a permanent establishment the profits that it 
would have earned had it been a distinct and separate 
enterprise engaged in the same or similar activities under the 
same or similar conditions and dealing wholly independently 
with the enterprise of which it is a permanent establishment.
    The ``attributable to'' concept of paragraph 2 provides an 
alternative to the analogous but somewhat different 
``effectively connected'' concept in Code section 864(c). 
Depending upon 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, 
as stated in paragraph 5 of the Protocol, 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 5 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.
    For example, 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 rule provided by the Convention 
is that such internal dealings may be used to attribute income 
to a permanent establishment in cases where the dealings 
accurately reflect the allocation of risk within the 
enterprise. One example is that of global trading in 
securities. In many cases, banks use internal swap transactions 
to transfer risk from one branch to a central location where 
traders have the expertise to manage that particular type of 
risk. Under the Convention, such a bank may also use such swap 
transactions as a means of attributing income between the 
branches, if use of that method is the ``best method'' within 
the meaning of Treas. Reg. 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 if properly allocable thereto. The 
amount of expense that must be allowed as a deduction is 
determined by applying the arm's length principle. 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 5 of the Protocol provides that 
the OECD Transfer Pricing Guidelines apply, by analogy, in 
determining the profits attributable to a permanent 
establishment. Accordingly, a permanent establishment may 
deduct payments made to its head office or another branch in 
compensation for services performed for the benefit of the 
branch. The method to be used in calculating that amount will 
depend on the terms of the arrangements between the branches 
and head office. For example, the enterprise could have a 
policy, expressed in writing, under which each business unit 
could use the services of lawyers employed by the head office. 
At the end of each year, the costs of employing the lawyers 
would be charged to each business unit according to the amount 
of services used by that business unit during the year. Since 
this appears to be a kind of cost-sharing arrangement and the 
allocation of costs is based on the benefits received by each 
business unit, such a cost allocation would be an acceptable 
means of determining a permanent establishment's deduction for 
legal expenses. Alternatively, the head office could agree to 
employ lawyers at its own risk, and to charge an arm's length 
price for legal services performed for a particular business 
unit. If the lawyers were under-utilized, and the ``fees'' 
received from the business units were less than the cost of 
employing the lawyers, then the head office would bear the 
excess cost. If the ``fees'' exceeded the cost of employing the 
lawyers, then the head office would keep the excess to 
compensate it for assuming the risk of employing the lawyers. 
If the enterprise acted in accordance with this agreement, this 
method would be an acceptable alternative method for 
calculating a permanent establishment's deduction for legal 
expenses.
    Paragraph 5 of the Protocol also makes clear that 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 does not have such capital, a 
Contracting State may, for profit attribution purposes, 
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 in 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, paragraph 5 of the Protocol 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.

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 (Dividends).
    As provided in Article 8 (International Traffic), 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.
    The Convention incorporates the rule of Code section 
864(c)(6). Like the Code section on which it is based, 
paragraph 5 of the Protocol 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 Article 7 
(Business Profits), paragraph 4 of Article 6 (Income from 
Immovable Property (Real Property)), paragraph 6 of Article 10 
(Dividends), paragraph 5 of Article 11 (Interest), paragraph 4 
of Article 12 (Royalties), paragraph 3 of Article 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 Bulgaria and 
that maintains a permanent establishment in the United States 
winds up the permanent establishment's business and sells the 
permanent establishment's inventory and assets to a U.S. buyer 
at the end of year 1 in exchange for an interest-bearing 
installment obligation payable in full at the end of year 3. 
Despite the fact that Article 13's threshold requirement for 
U.S. taxation is not met in year 3 because the company has no 
permanent establishment in the United States, the United States 
may tax the deferred income payment recognized by the company 
in year 3.

Relationship to other Articles

    This Article is subject to the saving clause of paragraph 4 
of Article 1 (General Scope). Thus, if a citizen of the United 
States who is a resident of Bulgaria 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 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 Bulgaria and 
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.

                   ARTICLE 8 (INTERNATIONAL TRAFFIC)

    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(j) 
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 Bulgaria, 
Bulgaria 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 establish*ments if the income were covered 
by Article 7 (Business Profits).

Paragraph 2

    The income from the operation of ships or aircraft in 
international traffic that is exempt from tax under paragraph 1 
is defined in paragraph 2.
    In addition to income derived directly from the operation 
of ships and aircraft in international traffic, this definition 
also includes certain items of rental income. First, income of 
an enterprise of a Contracting State from the rental of ships 
or aircraft on a full basis (i.e., with crew) is income of the 
lessor from the operation of ships and aircraft in 
international traffic and, therefore, is exempt from tax in the 
other Contracting State under paragraph 1. Also, paragraph 2 
encompasses income from the lease of ships or aircraft on a 
bareboat basis (i.e., without crew) when the income is 
incidental to other income of the lessor from the operation of 
ships or aircraft in international traffic. If the income is 
not incidental to other income of the lessor from the operation 
of ships or aircraft in international traffic, income from 
bareboat rentals would constitute business profits.
    Paragraph 6 of the Protocol clarifies, consistent with the 
U.S. Model and the Commentary to Article 8 of the OECD Model, 
that profits derived by an enterprise from the inland transport 
of tangible property or passengers within either Contracting 
State is treated as profits from the operation of ships or 
aircraft in international traffic if such transport is 
undertaken as part of international traffic. Thus, if a U.S. 
shipping company contracts to carry property from Bulgaria 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 
Bulgaria (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 
Commentary to Article 8 of the OECD Model.

Paragraph 3

    Under this paragraph, profits of an enterprise of a 
Contracting State from the use, maintenance or rental of 
containers (including equipment for their transport) used for 
the transport of goods or merchandise are exempt from tax in 
the other Contracting State, unless those containers are used 
for transport solely 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 
paragraphs 4 and 5 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 Bulgaria 
derives profits from the operation of ships or aircraft in 
international traffic, notwithstanding the exclusive residence 
country taxation in paragraph 1 of Article 8, the United States 
may, subject to the special foreign tax credit rules of 
paragraph 4 of Article 22 (Relief from Double Taxation), tax 
those profits as part of the worldwide income of the citizen. 
(This is an unlikely situation, however, because non-tax 
considerations (e.g., insurance) generally result in shipping 
activities being carried on in corporate form.)

                   ARTICLE 9 (ASSOCIATED ENTERPRISES)

    This Article incorporates in the Convention the arm's-
length principle reflected in the U.S. domestic transfer 
pricing provisions, particularly Code section 482. It provides 
that when related enterprises engage in a transaction on terms 
that are not arm's-length, the Contracting States may make 
appropriate adjustments to the taxable income and tax liability 
of such related enterprises to reflect what the income and tax 
of these enterprises with respect to the transaction would have 
been had there been an arm's-length relationship between them.

Paragraph 1

    This paragraph is essentially the same as its counterpart 
in the U.S. and OECD Models. It addresses the situation where 
an enterprise of a Contracting State is related to an 
enterprise of the other Contracting State, and there are 
arrangements or conditions imposed between the enterprises in 
their commercial or financial relations that are different from 
those that would have existed in the absence of the 
relationship. Under these circumstances, the Contracting States 
may adjust the income (or loss) of the enterprise to reflect 
what it would have been in the absence of such a relationship.
    The paragraph identifies the relationships between 
enterprises that serve as a prerequisite to application of the 
Article. As the Commentary to the OECD Model makes clear, the 
necessary element in these relationships is effective control, 
which is also the standard for purposes of section 482. Thus, 
the Article applies if an enterprise of one State participates 
directly or indirectly in the management, control, or capital 
of the enterprise of the other State. Also, the Article applies 
if any third person or persons participate directly or 
indirectly in the management, control, or capital of 
enterprises of different States. For this purpose, all types of 
control are included, i.e., whether or not legally enforceable 
and however exercised or exercisable.
    The fact that a transaction is entered into between such 
related enterprises does not, in and of itself, mean that a 
Contracting State may adjust the income (or loss) of one or 
both of the enterprises under the provisions of this Article. 
If the conditions of the transaction are consistent with those 
that would be made between independent persons, the income 
arising from that trans-action should not be subject to 
adjustment under this Article.
    Similarly, the fact that associated enterprises may have 
concluded arrangements, such as cost sharing arrangements or 
general services agreements, is not in itself an indication 
that the two enterprises have entered into a non-arm's-length 
transaction that should give rise to an adjustment under 
paragraph 1. Both related and unrelated parties enter into such 
arrangements (e.g., joint venturers may share some development 
costs). As with any other kind of transaction, when related 
parties enter into an arrangement, the specific arrangement 
must be examined to see whether or not it meets the arm's-
length standard. In the event that it does not, an appropriate 
adjustment may be made, which may include modifying the terms 
of the agreement or re-characterizing the transaction to 
reflect its substance.
    It is understood that the ``commensurate with income'' 
standard for determining appropriate transfer prices for 
intangibles, added to Code section 482 by the Tax Reform Act of 
1986, was designed to operate consistently with the arm's-
length standard. The implementation of this standard in the 
section 482 regulations is in accordance with the general 
principles of paragraph 1 of Article 9 of the Convention, as 
interpreted by the OECD Transfer Pricing Guidelines.
    This Article also permits tax authorities to deal with thin 
capitalization issues. They may, in the context of Article 9, 
scrutinize more than the rate of interest charged on a loan 
between related persons. They also may examine the capital 
structure of an enterprise, whether a payment in respect of 
that loan should be treated as interest, and, if it is treated 
as interest, under what circumstances interest deductions 
should be allowed to the payor. Paragraph 3 of the Commentary 
to Article 9 of the OECD Model, together with the U.S. 
observation set forth in paragraph 15, sets forth a similar 
understanding of the scope of Article 9 in the context of thin 
capitalization.

Paragraph 2

    When a Contracting State has made an adjustment that is 
consistent with the provisions of paragraph 1, and the other 
Contracting State agrees that the adjustment was appropriate to 
reflect arm's-length conditions, that other Contracting State 
is obligated to make a correlative adjustment (sometimes 
referred to as a ``corresponding adjustment'') to the tax 
liability of the related person in that other Contracting 
State. Although the OECD Model does not specify that the other 
Contracting State must agree with the initial adjustment before 
it is obligated to make the correlative adjustment, the 
Commentary makes clear that the paragraph is to be read that 
way.
    As explained in the Commentary to Article 9 of the OECD 
Model, Article 9 leaves the treatment of ``secondary 
adjustments'' to the laws of the Contracting States. When an 
adjustment under Article 9 has been made, one of the parties 
will have in its possession funds that it would not have had at 
arm's length. The question arises as to how to treat these 
funds. In the United States the general practice is to treat 
such funds as a dividend or contribution to capital, depending 
on the relationship between the parties. Under certain 
circumstances, the parties may be permitted to restore the 
funds to the party that would have the funds had the 
transactions been entered into on arm's length terms, and to 
establish an account payable pending restoration of the funds. 
See Rev. Proc. 99-32, 1999-2 C.B. 296.
    The Contracting State making a secondary adjustment will 
take the other provisions of the Convention, where relevant, 
into account. For example, if the effect of a secondary 
adjustment is to treat a U.S. corporation as having made a 
distribution of profits to its parent corporation in Bulgaria, 
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) Bulgaria 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 
(Mutual Agreement Procedure), notwithstanding any time limits 
or other procedural limitations in the law of the Contracting 
State making the adjustment. If a taxpayer has entered into 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 Bulgaria. See, Rev. Proc. 2006-54, 
2006-2 C.B. 1035, Section 7.05.

Relationship to other Articles

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

                         ARTICLE 10 (DIVIDENDS)

    Article 10 provides rules for the taxation of dividends 
paid by a company that is a resident of one Contracting State 
to a beneficial owner that is a resident of the other 
Contracting State. The Article provides for full residence 
country 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 State of residence 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 4. 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 10 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 
voting power of the company paying the dividend, then the rate 
of withholding tax in the State of source is limited to 5 
percent of the gross amount of the dividend. Shares are 
considered voting shares if they provide the power to elect, 
appoint or replace any person vested with the powers ordinarily 
exercised by the board of directors of a U.S. corporation.
    The benefits of paragraph 2 may be granted at the time of 
payment by means of reduced rate of withholding tax at source. 
It also is consistent with the paragraph for tax to be withheld 
at the time of payment at full statutory rates, and the treaty 
benefit to be granted by means of a subsequent refund so long 
as such procedures are applied in a reasonable manner.
    The determination of whether the ownership threshold for 
subparagraph 2(a) is met for purposes of the 5 percent maximum 
rate of withholding tax is made on the date on which 
entitlement to the dividend is determined. Thus, in the case of 
a dividend from a U.S. company, the determination of whether 
the ownership threshold is met generally would be made on the 
dividend record date.
    Paragraph 2 does not affect the taxation of the profits out 
of which the dividends are paid. The taxation by a Contracting 
State of the income of its resident companies is governed by 
the internal law of the Contracting State, subject to the 
provisions of paragraph 4 of Article 23 (Non-Discrimination).
    The term ``beneficial owner'' is not defined in the 
Convention, and is, therefore, defined as under the internal 
law of the country imposing tax (i.e., the source country). The 
beneficial owner of the dividend for purposes of Article 10 is 
the person to which the dividend income is attributable for tax 
purposes under the laws of the source State. Thus, if a 
dividend paid by a corporation that is a resident of one of the 
States (as determined under Article 4 (Resident)) is received 
by a nominee or agent that is a resident of the other State on 
behalf of a person that is not a resident of that other State, 
the dividend is not entitled to the benefits of this Article. 
However, a dividend received by a nominee on behalf of a 
resident of that other State would be entitled to benefits. 
These limitations are confirmed by paragraph 12 of the 
Commentary to Article 10 of the OECD Model.
    Special rules, however, apply to shares that are held 
through fiscally transparent entities. In that case, the rules 
of paragraph 6 of Article 1 (General Scope) will apply to 
determine whether the dividends should be treated as having 
been derived by a resident of a Contracting State. Residence 
State principles shall be used to determine who derives the 
dividend, to assure that the dividends for which the source 
State grants benefits of the Convention will be taken into 
account for tax purposes by a resident of the residence State. 
Source state principles of beneficial ownership shall then 
apply to determine whether the person who derives the 
dividends, or another resident of the other Contracting State, 
is the beneficial owner of the dividend. The source State may 
conclude that the person who derives the dividend in the 
residence State is a mere nominee, agent, conduit, etc., for a 
third country resident and deny benefits of the Convention. If 
the person who derives the dividend under paragraph 6 of 
Article 1 would not be treated under the source State's 
principles for determining beneficial ownership as a nominee, 
agent, custodian, conduit, etc., that person will be treated as 
the beneficial owner of the income, profits or gains for 
purposes of the Convention.
    Assume, for instance, that a company resident in Bulgaria 
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 Bulgarian 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. 
Bulgaria's principles of beneficial ownership shall then be 
applied to USCo. If under the laws of Bulgaria 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 BulCo, a company that is a 
resident of Bulgaria, 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. Bulgaria views ThirdDE as fiscally transparent 
under its domestic law, and taxes BulCo currently on the income 
derived by ThirdDE. In this case, BulCo is treated as deriving 
the dividends paid by USCo under paragraph 6 of Article 1. 
Moreover, BulCo 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 Bulgaria. Assuming 
that ThirdDE is treated as non-fiscally transparent by 
Bulgaria, the income will not be treated as derived by a 
resident of Bulgaria 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 (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 4 in the case of dividends paid by 
a RIC or a REIT.
    The first sentence of subparagraph 3(a) provides that 
dividends paid by a RIC or a 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 
10 percent maximum rate of withholding tax of subparagraph 2(b) 
applies to dividends paid by RICs and that the elimination of 
source-country withholding tax of paragraph 4 applies to 
dividends paid by RICs and beneficially owned by a pension 
fund.The third sentence of subparagraph 3(a) provides that the 
10 percent rate of withholding tax also applies to dividends 
paid by a REIT, and that the elimination of source-country 
withholding tax of paragraph 4 applies to dividends paid by 
REITs and beneficially owned by a pension fund, 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.
    Subparagraph (b) provides that the rules of subparagraph 
(a) shall also apply to dividends paid by companies resident in 
Bulgaria that are similar to a RIC or a REIT. Whether companies 
that are residents of Bulgaria are similar to RICs or REITs 
will be determined by mutual agreement of the competent 
authorities.The restrictions set out above are intended to 
prevent the use of these entities to gain inappropriate tax 
benefits. For example, a company resident in Bulgaria 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 10 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 10 percent maximum rate of 
withholding tax, into direct investment dividends taxable at a 
5 percent maximum rate of withholding tax.
    Similarly, a resident of Bulgaria 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 10 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, notwithstanding paragraph 2, the 
State of source will not tax dividends beneficially owned by a 
pension fund resident in the other Contracting State, unless 
such dividends are derived from the carrying on of a business 
by the pension fund or from an associated enterprise that is 
not itself a pension fund resident in the other Contracting 
State. For these purposes, the term ``pension fund'' is defined 
in subparagraph 1(m) of Article 3 (General Definitions).
    The exemption is provided because pension funds normally do 
not pay tax (either through a general exemption or because 
reserves for future pension liabilities effectively offset all 
of the fund's income), and therefore cannot benefit from a 
foreign tax credit. Moreover, distributions from a pension fund 
generally do not maintain the character of the underlying 
income, so the beneficiaries of the pension are not in a 
position to claim a foreign tax credit when they finally 
receive the pension, in many cases years after the withholding 
tax has been paid. Accordingly, in the absence of this rule, 
the dividends would almost certainly be subject to unrelieved 
double taxation.

Paragraph 5

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

Paragraph 6

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

Paragraph 7

    The right of a Contracting State to tax dividends paid by a 
company that is a resident of the other Contracting State is 
restricted by paragraph 7 to cases in which the dividends are 
paid to a resident of that Contracting State or are 
attributable to a permanent establishment 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(e) 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 under U.S. law. Section 884 
defines the dividend equivalent amount as an amount for a 
particular year that is equivalent to the income described 
above that is included in the corporation's effectively 
connected earnings and profits for that year, after payment of 
the corporate tax under Article 6, Article 7, or Article 13, 
reduced for any increase in the branch's U.S. net equity during 
the year or increased for any reduction in its U.S. net equity 
during the year. U.S. net equity is U.S. assets less U.S. 
liabilities. See Treas. Reg. section 1.884-1.
    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 Bulgaria 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 Explanation to paragraph 2 of 
Article 1, consistency principles require that a taxpayer may 
not use both treaty and Code rules where doing so would thwart 
the intent of either set of rules. 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 those 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.
    Subparagraph b) 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 
arising in one Contracting State and paid to a resident of the 
other Contracting State.

Paragraph 1

    Paragraph 1 generally grants to the State of residence the 
non-exclusive right to tax interest arising in the other 
Contracting State and paid to its residents.

Paragraph 2

    Paragraph 2 provides that the State of source also may tax 
the interest, but if the interest is beneficially owned by a 
resident of the other Contracting State, the rate of tax will 
be limited to 5 percent of the gross amount of the interest.
    The term ``beneficial owner'' is not defined in the 
Convention, and is, therefore, defined under the internal law 
of the State of source. The beneficial owner of the interest 
for purposes of Article 11 is the person to which the income is 
attributable under the laws of the source State. Thus, if 
interest arising in a Contracting State is received by a 
nominee or agent that is a resident of the other State on 
behalf of a person that is not a resident of that other State, 
the interest is not entitled to the benefits of Article 11. 
However, interest received by a nominee on behalf of a resident 
of that other State would be entitled to benefits. These 
limitations are confirmed by paragraph 9 of the OECD Commentary 
to Article 11.

Paragraph 3

    Paragraph (3) provides for exclusive residence-based 
taxation in certain cases.
    Under subparagraph (a), interest beneficially owned by a 
Contracting State, a political subdivision, or a local 
authority thereof (i.e., in the United States, a State or local 
government), the central bank of that Contracting State or any 
institution wholly owned by that Contracting State is subject 
to exclusive residence-based taxation.
    Under subparagraph (b), interest beneficially owned by a 
resident of a Contracting State with respect to debt-claims 
guaranteed, insured or indirectly financed by the Contracting 
State, a political subdivision or a local authority thereof, 
the central bank of that Contracting State or any institution 
wholly owned by that Contracting State is subject to exclusive 
residence-based taxation.
    Under subparagraph (c), interest beneficially owned by any 
financial institution, including, for example, a bank or an 
insurance company, is subject to exclusive residence-based 
taxation, unless the interest is paid as a part of a back-to-
back loan or an arrangement that is economically similar to and 
has the effect of a back-to-back loan. Paragraph 8 of the 
Protocol clarifies that the term ``back-to-back loan'' as used 
in subparagraph c) means a loan structured to obtain the 
benefits of subparagraph c) in which the loan is made to a 
financial institution that in turn lends the funds directly to 
the intended borrower. By referencing arrangements that are 
economically similar to, and that have the effect of, a back-
to-back loan, paragraph (3)(c) reaches transactions that would 
not meet the legal requirements of a loan, but would 
nevertheless serve that purpose economically. For example, the 
term would encompass securities issued at a discount, or 
certain swap arrangements intended to operate as the economic 
equivalent of a back to-back loan. In addition, nothing in 
Article 11 is intended to limit the ability of the Contracting 
States to enforce their domestic anti-avoidance provisions.
    Subparagraph (d) provides for exclusive residence-based 
taxation of interest beneficially owned by a pension fund 
resident in the other Contracting State, provided that the 
interest is not derived from the carrying on of a business, 
directly or indirectly, by the pension fund.

Paragraph 4

    The term ``interest'' as used in Article 11 is defined in 
paragraph 4 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 5

    Paragraph 5 provides an exception to the rules of 
paragraphs 1, 2 and 3 in cases where the beneficial owner of 
the interest carries on business through a permanent 
establishment in the State of source 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 5 also apply to interest that would be attributable 
to such a permanent establishment if it did exist in the year 
of payment or accrual. See the Technical Explanation to Article 
7.

Paragraph 6

    Paragraph 6 provides a source rule for determining the 
source of interest that is identical in substance to the 
interest source rule of the OECD Model. Interest is considered 
to arise in a Contracting State if paid by a resident of that 
State. As an exception, interest on a debt incurred in 
connection with a permanent establishment in one of the States 
and borne by the permanent establishment is considered to arise 
in that State. For this purpose, interest is considered to be 
borne by a permanent establishment if it is allocable to 
taxable income of that permanent establishment.

Paragraph 7

    Paragraph 7 provides that in cases involving special 
relationships between the payor and the beneficial owner of 
interest income, Article 11 applies only to that portion of the 
total interest payments that would have been made absent such 
special relationships (i.e., an arm's-length interest payment). 
Any excess amount of interest paid remains taxable according to 
the laws of the United States and Bulgaria, 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 payor 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 4. The United States would 
apply section 482 or 7872 of the Code to determine the amount 
of imputed interest in those cases.

Paragraph 8

    Paragraph 8 provides anti-abuse exceptions to the rules of 
paragraphs 2 and 3 for two classes of interest payments.
    The first class of interest, dealt with in subparagraphs 
(a) and (b) is so-called ``contingent interest.'' With respect 
to interest arising in the United States, subparagraph (a) 
refers to contingent interest of a type that does not qualify 
as portfolio interest under U.S. domestic law. The cross-
reference to the U.S. definition of contingent interest, which 
is found in section 871 (h)(4) of the Code, is intended to 
ensure that the exceptions of section 871 (h)(4)(c) will be 
applicable. With respect to Bulgaria, such interest is defined 
in subparagraph (b) as any interest arising in Bulgaria 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. Any interest 
dealt with in subparagraphs (a) and (b) may be taxed in the 
source State at a rate not exceeding 10 percent of the gross 
amount of the interest.
    The second class of interest is dealt with in subparagraph 
8(c). 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.

Paragraph 9

    Paragraph 9 permits a Contracting State to impose its 
branch level interest tax on a corporation resident in the 
other Contracting State. The base of this tax is the excess, if 
any, of the interest deductible in the first-mentioned 
Contracting State in computing the profits of the corporation 
that are subject to tax in the first-mentioned Contracting 
State and either attributable to a permanent establishment in 
the first-mentioned Contracting State or subject to tax in the 
first-mentioned Contracting State under Article 6 or Article 13 
of the Convention over the interest paid by the permanent 
establishment or trade or business in the first-mentioned 
Contracting State. Such excess interest may be taxed as if it 
were interest arising in the first-mentioned Contracting State 
and beneficially owned by the corporation resident in the other 
Contracting State. Thus, such excess interest may be taxed by 
the Contracting State of source at a rate not to exceed the 5 
percent rate provided for in paragraph 2, and shall be exempt 
from tax by the Contracting State of source if the recipient is 
described in paragraph 3.

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 
this Article 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).

Agreement to Reconsider Withholding Rates

    The Convention permits positive rates of taxation on 
interest and royalties. Paragraph 7 of the Protocol evidences 
the agreement of the Contracting States to reconsider the 
provisions of Article 11 and Article 12 with respect to 
interest and royalties arising in Bulgaria where the beneficial 
owner of the income is a U.S. resident. Such reconsideration is 
permitted to occur at an appropriate time, consistent with the 
December 31, 2014 conclusion of the transition period 
applicable to interest and royalties deemed to arise in 
Bulgaria that are beneficially owned by a resident of the 
European Union pursuant to Council Directive 2003/49/EC of 3 
June 2003, on a common system of taxation applicable to 
interest and royalty payments made between associated companies 
of different Member States.

                         ARTICLE 12 (ROYALTIES)

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

Paragraph 1

    Paragraph 1 grants the State of residence the non-exclusive 
right to tax a royalty arising in the other Contracting State 
and paid to its residents.

Paragraph 2

    Paragraph 2 allows the State of source to tax royalties 
arising in that State. 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.
    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 3

    The term ``royalties'' as used in this Article means:
    Paragraph 3 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 (including cinematographic films and films, tapes 
or other means of image or sound reproduction for radio or 
television broadcasting), any patent, trademark, design or 
model, plan, secret formula or process, or for information 
concerning industrial, commercial, or scientific experience. 
The term ``royalties'' also includes gain derived from the 
alienation of any right or property that would give rise to 
royalties, to the extent the gain is contingent on the 
productivity, use, or further alienation thereof. Gains that 
are not so contingent are dealt with under Article 13 (Capital 
Gains). The term ``royalties,'' however, does not include 
income from leasing personal property.
    The term royalties is defined in the Convention and 
therefore is generally independent of domestic law. Certain 
terms used in the definition are not defined in the Convention, 
but these may be defined under domestic tax law. For example, 
the term ``secret process or formulas'' is found in the Code, 
and its meaning has been elaborated in the context of sections 
351 and 367. See Rev. Rul. 55- 17, 1955-1 C.B. 388; Rev. Rul. 
64-56, 1964-1 C.B. 133; Rev. Proc. 69- 19, 1969-2 C.B. 301.
    Consideration for the use or right to use cinematographic 
films, or works on film, tape, or other means of reproduction 
in radio or television broadcasting is specifically included in 
the definition of royalties. It is intended that, with respect 
to any subsequent technological advances in the field of radio 
or television broadcasting, consideration received for the use 
of such technology will also be included in the definition of 
royalties.
    If an artist who is resident in one Contracting State 
records a performance in the other Contracting State, retains a 
copyrighted interest in a recording, and receives payments for 
the right to use the recording based on the sale or public 
playing of the recording, then the right of such other 
Contracting State to tax those payments is governed by Article 
12. See Boulez v. Commissioner, 83 T.C. 584 (1984), aff'd, 810 
F.2d 209 (D.C. Cir. 1986). By contrast, if the artist earns in 
the other Contracting State income covered by Article 16 
(Entertainers and Sportsmen), for example, endorsement income 
from the artist's attendance at a film screening, and if such 
income also is attributable to one of the rights described in 
Article 12 (e.g., the use of the artist's photograph in 
promoting the screening), Article 16 and not Article 12 is 
applicable to such income.
    Computer software generally is protected by copyright laws 
around the world. Under the Convention, consideration received 
for the use, or the right to use, computer software is treated 
either as royalties or as business profits, depending on the 
facts and circumstances of the transaction giving rise to the 
payment.
    The primary factor in determining whether consideration 
received for the use, or the right to use, computer software is 
treated as royalties or as business profits is the nature of 
the rights transferred. See Treas. Reg. section 1.861-18. The 
fact that the transaction is characterized as a license for 
copyright law purposes is not dispositive. For example, a 
typical retail sale of ``shrink wrap'' software generally will 
not be considered to give rise to royalty income, even though 
for copyright law purposes it may be characterized as a 
license.
    The means by which the computer software is transferred are 
not relevant for purposes of the analysis. Consequently, if 
software is electronically transferred but the rights obtained 
by the transferee are substantially equivalent to rights in a 
program copy, the payment will be considered business 
profits.The term ``industrial, commercial, or scientific 
experience'' (sometimes referred to as ``know-how'') has the 
meaning ascribed to it in paragraph 11 et seq. of the 
Commentary to Article 12 of the OECD Model. Consistent with 
that meaning, the term may include information that is 
ancillary to a right otherwise giving rise to royalties, such 
as a patent or secret process.
    Know-how also may include, in limited cases, technical 
information that is conveyed through technical or consultancy 
services. It does not include general educational training of 
the user's employees, nor does it include information developed 
especially for the user, such as a technical plan or design 
developed according to the user's specifications. Thus, as 
provided in paragraph 11.4 of the Commentary to Article 12 of 
the OECD Model, the term ``royalties'' does not include 
payments received as consideration for after-sales service, for 
services rendered by a seller to a purchaser under a warranty, 
or for pure technical assistance.
    The term ``royalties'' also does not include payments for 
professional services (such as architectural, engineering, 
legal, managerial, medical, software development services). For 
example, income from the design of a refinery by an engineer 
(even if the engineer employed know-how in the process of 
rendering the design) or the production of a legal brief by a 
lawyer is not income from the transfer of know-how taxable 
under Article 12, but is income from services taxable under 
either Article 7 (Business Profits) or Article 14 (Income from 
Employment). Professional services may be embodied in property 
that gives rise to royalties, however. Thus, if a professional 
contracts to develop patentable property and retains rights in 
the resulting property under the development contract, 
subsequent license payments made for those rights would be 
royalties.

Paragraph 4

    This paragraph provides an exception to the manner of 
allocating taxing rights specified in paragraphs 1 and 2 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 
(Business Profits) will apply.
    The provisions of paragraph 5 of the Protocol, regarding 
Article 7 (Business Profits), 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 re-ceived after the permanent 
establishment no longer exists, remains taxable under the 
provisions of Article 7 (Business Profits), and not under this 
Article.

Paragraph 5

    Paragraph 5 contains a source rule for determining the 
source of 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 relate to 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).Agreement to Reconsider Withholding 
Rates
    The Convention permits positive rates of taxation on 
interest and royalties. Paragraph 7 of the Protocol evidences 
the agreement of the Contracting States to reconsider the 
provisions of Article 11 and Article 12 with respect to 
interest and royalties arising in Bulgaria where the beneficial 
owner of the income is a U.S. resident. Such reconsideration is 
permitted to occur at an appropriate time, consistent with the 
December 31, 2014 conclusion of the transition period 
applicable to interest and royalties deemed to arise in 
Bulgaria that are beneficially owned by a resident of the 
European Union pursuant to Council Directive 2003/49/EC of 3 
June 2003, on a common system of taxation applicable to 
interest and royalty payments made between associated companies 
of different Member States.

                       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 gains attributable to the 
alienation of real property situated in that State. The 
paragraph therefore permits the United States to apply section 
897 of the Code to tax gains derived by a resident of Bulgaria 
that are attributable to the alienation of real property 
situated in the United States (as defined in paragraph 2). 
Gains attributable to the alienation of real property include 
gains from any other property that is treated as a real 
property interest within the meaning of paragraph 2.
    Paragraph 1 refers to gains ``attributable to the 
alienation of immovable property (real property)'' rather than 
the OECD Model phrase ``gains from the alienation'' to clarify 
that the United States will look through distributions made by 
a REIT and certain RICs. Accordingly, distributions made by a 
REIT or certain RICs are taxable under paragraph 1 of Article 
13 (not under Article 10 (Dividends)) when they are 
attributable to gains derived from the alienation of real 
property.

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), a ``United States real 
property interest'' (when the United States is the other 
Contracting State under paragraph 1), and, as specified in 
paragraph 2(c), an equivalent interest in immovable property 
(real property) situated in Bulgaria.
    Under section 897(c) of the Code the term ``United States 
real property interest'' includes shares in a U.S. corporation 
that owns sufficient U.S. real property interests to satisfy an 
asset-ratio test on certain testing dates. The term also 
includes certain foreign corporations that have elected to be 
treated as U.S. corporations for this purpose. Section 897(i).
    Section 897(c)(3) provides that, in certain situations 
stock regularly traded on an established securities market will 
not be treated as a U.S. real property interest, even if the 
stock derives its value primarily from U.S. real property. With 
respect to Bulgaria, subparagraph 2(c)(i) of Article 13, 
provides an analogous carve-out in the case of stock regularly 
traded on an established securities market. The term 
``established securities market'' is defined in paragraph 9 of 
the Protocol to mean a national securities exchange which is 
officially recognized, sanctioned, or supervised by a 
governmental authority as well as an over the counter market. 
An over the counter market is any market reflected by the 
existence of an interdealer quotation system. An interdealer 
quotation system is any system of general circulation to 
brokers and dealers which regularly disseminates quotations of 
stocks and securities by identified brokers or dealers, other 
than by quotation sheets which are prepared and distributed by 
a broker or dealer in the regular course of business and which 
contain only quotations of such broker or dealer. This 
definition is consistent with the regulations under section 
897.

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 Bulgaria that is a partner in a partnership 
doing business in the United States generally will have a 
permanent establishment in the United States as a result of the 
activities of the partnership, assuming that the activities of 
the partnership rise to the level of a permanent establishment. 
Rev. Rul. 91-32, 1991-1 C.B. 107. Further, under paragraph 3, 
the United States generally may tax a partner's distributive 
share of income realized by a partnership on the disposition of 
movable property forming part of the business property of the 
partnership in the United States.
    The gains subject to paragraph 3 may be taxed in the State 
in which the permanent establishment is located, regardless of 
whether the permanent establishment exists at the time of the 
alienation. This rule incorporates the rule of section 
864(c)(6) of the Code. Accordingly, income that is attributable 
to a permanent establishment, but that is deferred and received 
after the permanent establishment no longer exists, may 
nevertheless be taxed by the State in which the permanent 
establishment was located.

Paragraph 4

    This paragraph limits the taxing jurisdiction of the State 
of source with respect to gains from the alienation of ships or 
aircraft 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 
or aircraft.
    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 (International Traffic).

Paragraph 5

    Paragraph 5 provides a rule similar to paragraph 4 with 
respect to gains from the alienation of containers and related 
personal property. Such gains derived by an enterprise of a 
Contracting State shall be taxable only in that Contracting 
State unless the containers were used for the transport of 
goods or merchandise solely within the other Contracting State. 
The other Contracting State may not tax such gain even if it is 
attributable to a permanent establishment maintained by the 
enterprise in that other Contracting State.

Paragraph 6

    Paragraph 6 provides that, if certain conditions are met, a 
Contracting State can tax gains from the alienation of shares 
of a resident company that are derived by a resident of the 
other Contracting State. This provision permits Bulgaria to 
continue to impose its tax on the gain derived by U.S. 
residents on the alienation of shares in Bulgarian companies in 
a narrow set of cases. The first requirement is that the 
alienation occurs within 12 months of the date that the shares 
are acquired. The second requirement is that the recipient of 
the gain must have owned, directly or indirectly, at least 25 
percent of the capital of the company at some time within the 
12-month period preceding the alienation. Finally, the 
provision provides that a Contracting State may not in any case 
tax gains derived by a resident of the other Contracting State 
from the alienation of shares of stock of public companies 
traded on an established securities market.
    As described above, the term ``established securities 
market'' is a national securities exchange which is officially 
recognized, sanctioned, or supervised by a governmental 
authority as well as an over the counter market. An over the 
counter market is any market reflected by the existence of an 
interdealer quotation system, and an interdealer quotation 
system is any system of general circulation to brokers and 
dealers which regularly disseminates quotations of stocks and 
securities by identified brokers or dealers, other than by 
quotation sheets which are prepared and distributed by a broker 
or dealer in the regular course of business and which contain 
only quotations of such broker or dealer.
    The United States will treat gain taxed by Bulgaria under 
this paragraph as of Bulgarian source to the extent necessary 
to permit a credit for the Bulgarian tax, subject to the 
limitations of U.S. law.
    Paragraph 6 is reciprocal. If the United States were to 
introduce such a tax, it could be imposed in accordance with 
the rules of this paragraph.

Paragraph 7

    Paragraph 7 clarifies the interrelationship between 
Articles 12 (Royalties) and 13 with respect to certain gains 
treated as royalties. Under subparagraph 3(b) of Article 12, 
the term royalties includes gain derived from the alienation of 
property that would give rise to royalties, to the extent the 
gain is contingent on the productivity, use, or further 
alienation thereof. Therefore, such royalties are governed by 
the provisions of Article 12 and not by this Article.

Paragraph 8

    Paragraph 8 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 7. For example, gain derived from shares, other than 
shares described in paragraphs 2, 3, or 6, 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.

Relationship to other Articles

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

                  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 Payments, 
Annuities, Alimony, and Child Support), and 18 (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 Payments, Annuities, Alimony, and Child 
Support) 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 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 Payments, Annuities, 
Alimony, and Child Support). Article 14 also applies to income 
derived from the exercise of stock options granted with respect 
to services performed in the host State, even if those stock 
options are exercised after the employee has left the source 
country. If Article 14 is found to apply, whether such payments 
were taxable in the State where the employment was exercised 
would depend on whether the tests of paragraph 2 were satisfied 
in the year in which the services to which the payment relates 
were performed.

Paragraph 2

    Paragraph 2 sets forth an exception to the general rule 
that employment income may be taxed in the State where it is 
exercised. Under paragraph 2, the State where the employment is 
exercised may not tax the income from the employment if three 
conditions are satisfied: (a) the individual is present in the 
other Contracting State for a period or periods not exceeding 
183 days in any 12-month period that begins or ends during the 
relevant taxable year (i.e., in the United States, the calendar 
year in which the services are performed); (b) the remuneration 
is paid by, or on behalf of, an employer who is not a resident 
of that other Contracting State; and (c) the remuneration is 
not borne as a deductible expense by a permanent establishment 
that the employer has in that other State. In order for the 
remuneration to be exempt from tax in the source State, all 
three conditions must be satisfied. This exception is identical 
to that set forth in the OECD Model.
    The 183-day period in condition (a) is to be measured using 
the ``days of physical presence'' method. Under this method, 
the days that are counted include any day in which a part of 
the day is spent in the host country. (Rev. Rul. 56-24, 1956-1 
C.B. 851.) Thus, days that are counted include the days of 
arrival and departure; weekends and holidays on which the 
employee does not work but is present within the country; 
vacation days spent in the country before, during or after the 
employment period, unless the individual's presence before or 
after the employment can be shown to be independent of his 
presence there for employment purposes; and time during periods 
of sickness, training periods, strikes, etc., when the 
individual is present but not working. If illness prevented the 
individual from leaving the country in sufficient time to 
qualify for the benefit, those days will not count. Also, any 
part of a day spent in the host country while in transit 
between two points outside the host country is not counted. If 
the individual is a resident of the host country for part of 
the taxable year concerned and a non-resident 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 crew of the ship or 
aircraft or as other personnel regularly employed to serve 
aboard the ship or aircraft. In the case of a cruise ship, for 
example, paragraph 3 applies to the crew and others, such as 
entertainers, lecturers, etc., employed by the shipping company 
to serve on the ship throughout its voyage. The use of the 
phrase ``regularly employed to serve'' 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.

Relationship to other Articles

    If a U.S. citizen who is resident in Bulgaria 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 member of the 
board of directors or a functionally similar body. 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. This provision of the Convention is identical in 
substance to the analogous provision in the OECD Model.

                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 $15,000 (or its 
equivalent in Bulgarian currency) for the taxable year. The 
$15,000 includes expenses reimbursed to the individual or borne 
on his behalf. If the gross receipts exceed $15,000, the full 
amount, not just the excess, may be taxed in the State of 
performance.
    This Convention introduces a monetary threshold to 
distinguish between two groups of entertainers and athletes--
those who are paid relatively large sums of money for very 
short periods of service, and who would, therefore, normally be 
exempt from host country tax under the standard personal 
services income rules, and those who earn relatively modest 
amounts and are, therefore, not easily distinguishable from 
those who earn other types of personal service income.
    Tax may be imposed under paragraph 1 even if the performer 
would have been exempt from tax under Article 7 (Business 
Profits) or 14 (Income from Employment). On the other hand, if 
the performer would be exempt from host-country tax under 
Article 16, but would be taxable under either Article 7 or 14, 
tax may be imposed under either of those Articles. Thus, for 
example, if a performer derives remuneration from his 
activities in an independent capacity, and the performer does 
not have a permanent establishment in the host State, he may be 
taxed by the host State in accordance with Article 16 if his 
remuneration exceeds $15,000 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 
$15,000 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.
    Since it frequently is not possible to know until year-end 
whether the income an entertainer or sportsman derived from 
performances in a Contracting State will exceed $15,000, 
nothing in the Convention precludes that Contracting State from 
withholding tax during the year and refunding it after the 
close of the year if the taxability threshold has not been met.
    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 (Business Profits). 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 (Business Profits) 
or 14 (Income from Employment).
    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 (Income from Employment), 
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 even if it was paid after the close of 
the year. The determination as to whether the $15,000 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 $15,000. Otherwise, residual payments received many 
years later could retroactively subject all earlier payments to 
tax by the other Contracting State.

Paragraph 2

    Paragraph 2 is intended to address the potential for 
circumvention of the rule in paragraph 1 when a performer's 
income does not accrue directly to the performer himself, but 
to another person. Foreign performers frequently perform in the 
United States as employees of, or under contract with, a 
company or other person.
    The relationship may truly be one of employee and employer, 
with no circumvention of paragraph 1 either intended or 
realized. On the other hand, the ``employer'' may, for example, 
be a company established and owned by the performer, which is 
merely acting as the nominal income recipient in respect of the 
remuneration for the performance (a ``star company''). The 
performer may act as an ``employee,'' receive a modest salary, 
and arrange to receive the remainder of the income from his 
performance from the company in another form or at a later 
time. In such case, absent the provisions of paragraph 2, the 
income arguably could escape host-country tax because the 
company earns business profits but has no permanent 
establishment in that country. The performer may largely or 
entirely escape host-country tax by receiving only a small 
salary, perhaps small enough to place him below the dollar 
threshold in paragraph 1. The performer might arrange to 
receive further payments in a later year, when he is not 
subject to host-country tax, perhaps as dividends or 
liquidating distributions.
    Paragraph 2 seeks to prevent this type of abuse while at 
the same time protecting the taxpayers' rights to the benefits 
of the Convention when there is a legitimate employee-employer 
relationship between the performer and the person providing his 
services. Under paragraph 2, when the income accrues to a 
person other than the performer, 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 (Article 7) or income from employment (Article 
14), but only if one of two conditions is met. The first 
condition is that the contract pursuant to which the personal 
activities are performed designates the entertainer or 
sportsman (by name or description). The second condition is 
that the contract allows the other party to the contract (or a 
person other than the entertainer, sportsman or the person to 
whom the income accrues) to designate the individual who is to 
perform the personal activities. This rule is consistent with 
the U.S. domestic law provision characterizing income from 
certain personal service contracts as foreign personal holding 
company income.
    The premise of this rule is that, in a case where a 
performer is using another person in an attempt to circumvent 
the provisions of paragraph 1, the recipient of the services of 
the performer would contract with a person other than that 
performer (i.e., a company employing the performer) only if the 
recipient of the services were certain that the performer 
himself would perform the services (i.e., the contract 
mentioned the performer by name or description or else allowed 
the recipient of the services to designate who is to perform 
the services). If instead the person to whom the income accrues 
is allowed to designate the individual who is to perform the 
services, then likely that person is a service company not 
formed to circumvent the provisions of paragraph 1. The 
following example illustrates the operation of this rule.
    Example. Company O, a resident of Bulgaria, is engaged in 
the business of operating an orchestra. Company O enters into a 
contract with Company A pursuant to which Company O agrees to 
carry out two performances in the United States in 
consideration of which Company A will pay Company O $200,000. 
The contract designates two individuals, a conductor and a 
flutist, that must perform as part of the orchestra, and allows 
Company O to designate the other members of the orchestra. 
Because the contract mentions by name the conductor and the 
flutist, the portion of the $200,000 that is attributable to 
the personal services of the conductor and the flutist may be 
taxed by the United States pursuant to paragraph 2. However, 
because Company A is not allowed to designate the other 
performers the remaining portion of the $200,000, is not 
subject to tax by the United States pursuant to paragraph 2.
    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.
    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.
    Pursuant to Article 1 (General Scope) the Convention only 
applies to persons who are residents of one of the Contracting 
States. Thus, income of a star company that is not a resident 
of one of the Contracting States would not be eligible for the 
benefits of the Convention.

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 Bulgaria 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, ANNUITIES, ALIMONY, AND CHILD 
                                SUPPORT)

    This Article deals with the taxation of private (i.e., non-
government service) pensions and annuities, social security 
benefits, alimony and child support payments.

Paragraph 1

    Paragraph 1 provides that distributions from pensions and 
other similar remuneration beneficially owned by a resident of 
a Contracting State in consideration of past employment are 
taxable only in the State of residence of the beneficiary. The 
term ``pensions and other similar remuneration'' includes both 
periodic and single sum payments.
    The phrase ``pensions and other similar remuneration'' is 
intended to encompass payments made by qualified private 
retirement plans. In the United States, the plans encompassed 
by paragraph 1 include: qualified plans under section 401(a), 
individual retirement plans (including individual retirement 
plans that are part of a simplified employee pension plan that 
satisfies section 408(k), individual retirement accounts and 
section 408(p) accounts), section 403(a) qualified annuity 
plans, and section 403(b) plans. Distributions from section 457 
plans may also fall under Paragraph 1 if they are not paid with 
respect to government services covered by Article 18.
    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, 401(a), 403(b) plans established for government employees, 
and the Thrift Savings Plan (section 7701(j)).

Paragraph 2

    The treatment of social security benefits is dealt with in 
paragraph 2. This paragraph provides that, notwithstanding the 
provision of paragraph 1 under which private pensions are 
taxable exclusively in the State of residence of the beneficial 
owner, payments made by one of the Contracting States under the 
provisions of its social security or similar legislation to a 
resident of Bulgaria 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 Bulgaria 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 deals with alimony and child support payments. 
Under paragraph 4, alimony and child support payments paid by a 
resident of a Contracting State to a resident of the other 
Contracting State are not taxable in the recipient's State of 
residence. In addition, such payments are not taxable in the 
payor's State of residence unless he is entitled to a deduction 
for such payments in computing taxable income in his State of 
residence. The term alimony is defined as periodic payments 
made pursuant to a written separation agreement or a decree of 
divorce, separate maintenance, or compulsory support.

Paragraph 5

    Paragraph 5 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 Bulgaria, paragraph 5 prevents Bulgaria 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 under paragraph 1.

Relationship to other Articles

    Paragraphs 1, 3, and 4 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 Bulgaria, and receives 
a pension, annuity or alimony payment from the United States, 
may be subject to U.S. tax on the payment, notwithstanding the 
rules in paragraphs 1, 3 and 4. Paragraphs 2 and 5 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 paragraph 2, even if 
such amounts otherwise would be subject to tax under U.S. law, 
and the United States will allow U.S. citizens and residents 
the benefits of paragraph 5.

              ARTICLE 18 (GOVERNMENT SERVICE) PARAGRAPH 1

    Paragraph 1 deals with the taxation of government 
compensation (other than a pension addressed in paragraph 2). 
Subparagraph (a) provides that remuneration paid to any 
individual who is rendering services to that State, political 
subdivision or local authority is exempt from tax by the other 
State. Under subparagraph (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 to that State or subdivision or 
authority. Subparagraph (a) provides that such pensions are 
taxable only in that State. Subparagraph (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 Payments, Annuities, Alimony, and Child 
Support). As a general matter, the result will be the same 
whether Article 17 or 18 applies, since social security 
benefits are taxable exclusively by the source country and so 
are government pensions. The result will differ only when the 
payment is made to a citizen and resident of the other 
Contracting State, who is not also a citizen of the paying 
State. In such a case, social security benefits continue to be 
taxable at source while government pensions become taxable only 
in the residence country.

Paragraph 3

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

Relationship to other Articles

    Under paragraph 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. An 
individual who receives a pension paid by the Government of 
Bulgaria in respect of services rendered to the Government of 
Bulgaria shall be taxable on this pension only in Bulgaria 
unless the individual is a U.S. citizen or acquires a U.S. 
green card.

       ARTICLE 19 (STUDENTS, TRAINEES, TEACHERS AND RESEARCHERS)

    This Article provides rules for host-country taxation of 
visiting students, business trainees, teachers and researchers. 
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. Paragraph 1 addresses payments 
received by a student or business trainee, while paragraph 2 
addresses teachers and researchers temporarily present in the 
host country.

Paragraph 1

    Subparagraph (a) addresses the situation where a student or 
business trainee that is a resident of a Contracting State 
receives designated classes of payments while present in the 
host State. Several conditions must be satisfied for such an 
individual to be entitled to the benefits of paragraph 1.First, 
the student or business trainee must have been, either at the 
time of his arrival in the host State or immediately before, a 
resident of the other Contracting State.
    Second, the purpose of the visit must be the full-time 
education (at a college, university, or other recognized 
educational institution of a similar nature) or full-time 
training of the visitor. Thus, if the visitor comes principally 
to work in the host State but also is a part-time student, he 
would not be entitled to the benefits of paragraph 1, even with 
respect to any payments he may receive from abroad for his 
maintenance or education, and regardless of whether or not he 
is in a degree program. Whether a student is to be considered 
full-time will be determined by the rules of the educational 
institution at which he is studying.
    The host-country exemption in paragraph 1 applies to 
payments received by the student or business trainee for the 
purpose of his maintenance, education or training that arise 
outside the host State. A payment will be considered to arise 
outside the host State if the payor is located outside the host 
State. Thus, if an employer from one of the Contracting States 
sends an employee to the other Contracting State for training, 
the payments the trainee receives from abroad from his employer 
for his maintenance or training while he is present in the host 
State will be exempt from tax in the host State. Where 
appropriate, substance prevails over form in determining the 
identity of the payor. Thus, for example, payments made 
directly or indirectly by a U.S. person with whom the visitor 
is training, but which have been routed through a source 
outside the United States (e.g., a foreign subsidiary), are not 
treated as arising outside the United States for this purpose.
    Paragraph 1 also provides a limited exemption for 
remuneration from personal services rendered in the host State 
with a view to supplementing the resources available to him for 
such purposes to the extent of $9,000 United States dollars (or 
its equivalent in the currency of Bulgaria) per taxable year. 
The competent authorities are instructed to adjust this amount 
every five years, if appropriate.
    In the case of a business trainee, the benefits of 
paragraph 1 will extend only for a period of two years from the 
time that the visitor first arrives in the host country for the 
purpose of training. If, however, a trainee remains in the host 
country for a third year, thus losing the benefits of paragraph 
1, he would not retroactively lose the benefits of the 
paragraph 1 for the first two years. The term ``business 
trainee'' is defined as a person who is in the country 
temporarily either for the purpose of securing training that is 
necessary to qualify to pursue a profession or professional 
specialty, or as an employee of, or under contract with, a 
resident of the other Contracting State, for the primary 
purpose of acquiring technical, professional, or business 
experience, from someone who is not his employer or related to 
his employer. Thus, a business trainee might include a lawyer 
employed by a law firm in one Contracting State who works for 
one year as a stagiare in an unrelated law firm in the other 
Contracting State. However, the term would not include a 
manager who normally is employed by a parent company in one 
Contracting State who is sent to the other Contracting State to 
run a factory owned by a subsidiary of the parent company.

Paragraph 2

    Paragraph 2 provides a limited exemption from host State 
taxation for certain teachers and researchers temporarily 
present in the host State for the purpose of teaching or 
carrying on research at a school, college, university or other 
recognized educational or research institution. The teacher or 
researcher must be a resident of the other Contracting State at 
the beginning of his visit to the host State. The income 
eligible for exemption is the person's remuneration received in 
consideration of teaching or carrying on research. The host-
country exemption will extend to payments received by a teacher 
or researcher only for a period of two years from the time that 
the visitor first arrives in the host country. A teacher or 
researcher remaining in the host country for more than 2 years 
becomes subject to tax on remuneration with respect to teaching 
and researching, but does not retroactively lose the benefits 
of paragraph 2 for the first two years. Paragraph 2 does not 
apply to exempt income in consideration of carrying on research 
if the research is primarily for the private benefit of a 
specific person or persons rather than in the public interest.

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 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, for example, a U.S. citizen 
who is a resident of Bulgaria 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. A person, 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 through 
19) of the Convention to the State of residence of the 
beneficial owner of the income. In order for an item of income 
to be ``dealt with'' in another article it must be the type of 
income described in the article and, in most cases, it must 
have its source in a Contracting State. For example, all 
royalty income that arises in a Contracting State and that is 
beneficially owned by a resident of the other Contracting State 
is ``dealt with'' in Article 12 (Royalties). However, profits 
derived in the conduct of a business are ``dealt with'' in 
Article 7 (Business Profits) whether or not they have their 
source in one of the Contracting States.
    Examples of items of income covered by Article 20 include 
income from gambling, punitive (but not compensatory) damages 
and covenants not to compete. The Article would also apply to 
income from a variety of financial transactions, where such 
income does not arise in the course of the conduct of a trade 
or business. For example, income from notional principal 
contracts and other derivatives would fall within Article 20 if 
derived by persons not engaged in the trade or business of 
dealing in such instruments, unless such instruments were being 
used to hedge risks arising in a trade or business. It would 
also apply to securities lending fees derived by an 
institutional investor. Further, in most cases guarantee fees 
paid within an intercompany group would be covered by Article 
20, unless the guarantor were engaged in the business of 
providing such guarantees to unrelated parties.
    Article 20 also applies to items of income that are not 
dealt with in the other articles because of their source or 
some other characteristic. For example, Article 11 (Interest) 
addresses only the taxation of interest arising in a 
Contracting State. Interest arising in a third State that is 
not attributable to a permanent establishment, therefore, is 
subject to Article 20.
    Distributions from partnerships are not generally dealt 
with under Article 20 because partnership distributions 
generally do not constitute income. Under the Code, partners 
include in income their distributive share of partnership 
income annually, and partnership distributions themselves 
generally do not give rise to income. This would also be the 
case under U.S. law with respect to distributions from trusts. 
Trust income and distributions that, under the Code, have the 
character of the associated distributable net income would 
generally be covered by another article of the Convention. See 
Code section 641 et seq.

Paragraph 1

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

Paragraph 2

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

Relationship to other Articles

    This Article is subject to the saving clause of paragraph 4 
of Article 1 (General Scope). Thus, the United States may tax 
the income of a resident of Bulgaria 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 Bulgaria earns income that falls within the scope 
of paragraph 1 of Article 20, 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 or 3, 
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 paragraphs 1 through 4 of Article 21. 
Paragraph 6 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 7 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 through 
20, the treaty-based relief from double taxation provided by 
Article 22 (Relief from Double Taxation), and the protection 
against discrimination 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 applies to diplomatic agents or consular 
officials regardless of residence. Article 21 accordingly does 
not limit the availability of treaty benefits under these 
provisions.
    Article 21 and the anti-abuse provisions of domestic law 
complement each other, as Article 21 effectively determines 
whether an entity has a sufficient nexus to the Contracting 
State to be treated as a resident for treaty purposes, while 
domestic anti-abuse provisions (e.g., business purpose, 
substance-over-form, step transaction or conduit principles) 
determine whether a particular transaction should be recast in 
accordance with its substance. Thus, internal law principles of 
the source Contracting State may be applied to identify the 
beneficial owner of an item of income, and Article 21 then will 
be applied to the beneficial owner to determine if that person 
is entitled to the benefits of the Convention with respect to 
such income.

Paragraph 2

    Paragraph 2 has five subparagraphs, each of which describes 
a category of residents that are entitled to all benefits of 
the Convention.
    It is intended that the provisions of paragraph 2 will be 
self executing. Unlike theprovisions of paragraph 6, discussed 
below, claiming benefits under paragraph 2 does not require an 
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 (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 (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 (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 (c) if the principal class of its shares, and 
any disproportionate class of 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 7(a). 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 Bulgarian Stock 
Exchange--Sofia, and any other stock exchange licensed to trade 
securities and financial instruments under the Bulgarian law; 
and (iii) any other stock exchange agreed upon by the competent 
authorities of the Contracting States.
    If a company has only one class of shares, it is only 
necessary to consider whether the shares of that class meet the 
relevant trading requirements. If the company has more than one 
class of shares, it is necessary as an initial matter to 
determine which class or classes constitute the ``principal 
class of shares''. The term ``principal class of shares'' is 
defined in subparagraph 7(b) 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.
    A company whose principal class of shares is regularly 
traded on a recognized stock exchange will nevertheless not 
qualify for benefits under subparagraph 2(c) if it has a 
disproportionate class of shares that is not regularly traded 
on a recognized stock exchange. The term ``disproportionate 
class of shares'' is defined in subparagraph 7(c). A company 
has a disproportionate class of shares if it has outstanding 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, profit, or gain in the other Contracting State than 
that to which the holder would be entitled in the absence of 
such terms or arrangements. Thus, for example, a company 
resident in Bulgaria has a disproportionate class of shares if 
it has outstanding a class of ``tracking stock'' that pays 
dividends based upon a formula that approximates the company's 
return on its assets employed in the United States.
    The following example illustrates this result.
    Example. BulCo is a corporation resident in Bulgaria. BulCo 
has two classes of shares: Common and Preferred. The Common 
shares are listed and regularly traded on the principal stock 
exchange of Bulgaria. The Preferred shares have no voting 
rights and are entitled to receive dividends equal in amount to 
interest payments that BulCo receives from unrelated borrowers 
in the United States. The Preferred shares are owned entirely 
by a single investor that is a resident of a country with which 
the United States does not have a tax treaty. The Common shares 
account for more than 50 percent of the value of BulCo and for 
100 percent of the voting power. Because the owner of the 
Preferred shares is entitled to receive payments corresponding 
to the U.S. source interest income earned by BulCo, the 
Preferred shares are a disproportionate class of shares. 
Because the Preferred shares are not regularly traded on a 
recognized stock exchange, BulCo will not qualify for benefits 
under subparagraph 2(c).
    A class of shares will be ``regularly traded'' on one or 
more recognized stock exchanges in a taxable year, under 
subparagraph 7(g), if the aggregate number of shares of that 
class traded on one or more recognized exchanges during the 
twelve months ending on the day before the beginning of that 
taxable year is at least six percent of the average number of 
shares outstanding in that class during that twelve-month 
period. 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 Bulgaria.
    The term ``primarily traded'' is not defined in the 
Convention. In accordance with paragraph 2 of Article 3 
(General Definitions), this term will have the meaning it has 
under the laws of the State concerning the taxes to which the 
Convention applies, generally the source State. In the case of 
the United States, this term is understood to have the meaning 
it has under Treas. Reg. section 1. 884-5(d)(3), relating to 
the branch tax provisions of the Code. Accordingly, stock of a 
corporation is ``primarily traded'' if the number of shares in 
the company's principal class of shares that are traded during 
the taxable year on all recognized stock exchanges in the 
Contracting State of which the company is a resident exceeds 
the number of shares in the company's principal class of shares 
that are traded during that year on established securities 
markets in any other single foreign country.
    A company whose principal class of shares is regularly 
traded on a recognized exchange but cannot meet the primarily 
traded test may claim treaty benefits if its primary place of 
management and control is in its country of residence. This 
test should be distinguished from the ``place of effective 
management'' test which is used in the OECD Model and by many 
other countries to establish residence. In some cases, the 
place of effective management test has been interpreted to mean 
the place where the board of directors meets. By contrast, the 
primary place of management and control test looks to where 
day-to-day responsibility for the management of the company 
(and its subsidiaries) is exercised. The company's primary 
place of management and control will be located in the State in 
which the company is a resident only if the executive officers 
and senior management employees exercise day-to-day 
responsibility for more of the strategic, financial and 
operational policy decision making for the company (including 
direct and indirect subsidiaries) in that State than in the 
other State or any third state, and the staff that support the 
management in making those decisions are also based in that 
State. Thus, the test looks to the overall activities of the 
relevant persons to see where those activities are conducted. 
In most cases, it will be a necessary, but not a sufficient, 
condition that the headquarters of the company (that is, the 
place at which the CEO 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 (and at least 50 percent of any 
disproportionate class of 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 
Bulgaria, all the shares of which are owned by another company 
that is a resident of Bulgaria, would qualify for benefits 
under the Convention if the principal class of shares (and any 
disproportionate classes of shares) of the parent company are 
regularly and primarily traded on a recognized stock exchange 
in Bulgaria. 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 Bulgaria. Furthermore, if a 
parent company in Bulgaria 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 Bulgaria 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 fund 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, a 
tax-exempt organization other than a pension fund automatically 
qualifies for benefits, without regard to the residence of its 
beneficiaries or members. Entities qualifying under this rule 
are those that are generally exempt from tax in their State of 
residence and that are organized and operated exclusively to 
fulfill religious, charitable, scientific, artistic, cultural, 
or educational purposes.
            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 (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 at least 50 percent of the aggregate voting power and 
value (and at least 50 percent of any disproportionate class of 
shares) 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), (b), (c)(i), or (d). In the case of indirect owners, 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 (Resident) 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 
the other provisions of paragraph 2 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), (b), 
(c)(i), or (d).
    The base erosion prong of clause (ii) of subparagraph (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 (a), (b), (c)(i), or 
(d), in the form of payments deductible for tax purposes in the 
payor's State of residence. These amounts do not include arm's-
length payments in the ordinary course of business for services 
or tangible property. 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.
    Subparagraph (a) sets forth the ownership test. Under this 
test, seven or fewer equivalent beneficiaries must own shares 
representing at least 95 percent of the aggregate voting power 
and value of the company and at least 50 percent of any 
disproportionate class of shares. Ownership may be direct or 
indirect. The term ``equivalent beneficiary'' is defined in 
subparagraph (e) of paragraph 7. This definition may be met in 
two alternative ways, the first of which has two requirements.
    Under the first alternative, a person may be an equivalent 
beneficiary 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. This alternative has two 
requirements.
    The first requirement is that the person must be a resident 
of a member state of the European Union, or of a European 
Economic Area state, or of a party to the North American Free 
Trade Agreement (collectively, ``qualifying States'').
    The second requirement of the definition of ``equivalent 
beneficiary'' is that the person must be entitled to equivalent 
benefits under an applicable treaty. To satisfy the second 
requirement, the person must be entitled to all the benefits of 
a comprehensive treaty 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 paragraph 2 
(a), (b), (c)(i), and (d) of this Article. 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), (b), (c)(i), and (d) of this Article if the person were a 
resident of one of the Contracting States.
    In order to satisfy the second requirement necessary to 
qualify as an ``equivalent beneficiary'' under subparagraph 
7(e)(i)(B) 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.
    Subparagraph 7(f) provides a special rule to take account 
of the fact that withholding taxes on many inter-company 
dividends, interest and royalties are exempt within the 
European Union by reason of various EU directives, rather than 
by tax treaty. If a U.S. company receives such payments from a 
Bulgarian company, and that U.S. company is owned by a company 
resident in a member state of the European Union that would 
have qualified for an exemption from withholding tax if it had 
received the income directly, the parent company will be 
treated as an equivalent beneficiary. This rule is necessary 
because many European Union member countries have not re-
negotiated their tax treaties to reflect the exemptions 
available under the directives.
    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 French parent of 
a Bulgarian company is engaged in the active conduct of a trade 
or business in France and therefore would be entitled to the 
benefits of the U.S.-France treaty if it received dividends 
directly from a U.S. subsidiary of the Bulgarian company is not 
sufficient for purposes of this paragraph. Further, the French 
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.-France treaty. 
However, it would be possible to look through the French 
company to its parent company to determine whether the parent 
company is an equivalent beneficiary.
    The second alternative for satisfying the ``equivalent 
beneficiary'' test is available only to residents of one of the 
two Contracting States. U.S. or Bulgarian residents who are 
eligible for treaty benefits by reason of subparagraphs 2(a), 
(b), (c)(i), or (d) are equivalent beneficiaries for purposes 
of the relevant tests in Article 21. Thus, a Bulgarian 
individual will be an equivalent beneficiary 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 these 
provisions by reason of those paragraphs or any other rule of 
the treaty, and therefore does not qualify as an equivalent 
beneficiary under this alternative. Thus, a resident of a third 
country can be an equivalent beneficiary 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 Bulgarian company under this 
paragraph. Thus, for example, if 90 percent of a Bulgarian 
company is owned by five companies that are resident in member 
states of the European Union who satisfy the requirements of 
subparagraph 7(e)(i), and 10 percent of the Bulgarian company 
is owned by a U.S. or Bulgarian individual, then the Bulgarian 
company still can satisfy the requirements of subparagraph 
3(a).
    Subparagraph 3(b) 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 equivalent 
beneficiaries in the form of payments deductible for tax 
purposes in company's State of residence. These amounts do not 
include arm's-length payments in the ordinary course of 
business for services or tangible property. This test is the 
same as the base erosion test in subparagraph 2(e)(ii), except 
that the test in paragraph 3(b) focuses on base-eroding 
payments to persons who are not equivalent beneficiaries.

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 (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 Bulgaria 
is entitled to the benefits of the Convention under paragraph 4 
of this Article with respect to an item of income derived from 
sources within the United States, the United States will 
ascribe to this term the meaning that it has under the law of 
the United States. Accordingly, the U.S. competent authority 
will refer to the regulations issued under section 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 4.
    An item of income is derived in connection with a trade or 
business if the income-producing activity in the State of 
source is a line of business that ``forms a part of'' or is 
``complementary'' to the trade or business conducted in the 
State of residence by the income recipient.
    A business activity generally will be considered to form 
part of a business activity conducted in the State of source if 
the two activities involve the design, manufacture or sale of 
the same products or type of products, or the provision of 
similar services. The line of business in the State of 
residence may be upstream, downstream, or parallel to the 
activity conducted in the State of source. Thus, the line of 
business may provide inputs for a manufacturing process that 
occurs in the State of source, may sell the output of that 
manufacturing process, or simply may sell the same sorts of 
products that are being sold by the trade or business carried 
on in the State of source.

    Example 1. USCo is a corporation resident in the United 
States. USCo is engaged in an active manufacturing business in 
the United States. USCo owns 100 percent of the shares of 
BulCo, a corporation resident in Bulgaria. BulCo distributes 
USCo products in Bulgaria. Since the business activities 
conducted by the two corporations involve the same products, 
BulCo'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 BulCo. BulCo and other USCo affiliates then 
manufacture and market the USCo-designed products in their 
respective markets. Since the activities conducted by BulCo and 
USCo involve the same product lines, these activities are 
considered to form a part of the same trade or business.
    For two activities to be considered to be 
``complementary,'' the activities need not relate to the same 
types of products or services, but they should be part of the 
same overall industry and be related in the sense that the 
success or failure of one activity will tend to result in 
success or failure for the other. Where more than one trade or 
business is conducted in the State of source and only one of 
the trades or businesses forms a part of or is complementary to 
a trade or business conducted in the State of residence, it is 
necessary to identify the trade or business to which an item of 
income is attributable. Royalties generally will be considered 
to be derived in connection with the trade or business to which 
the underlying intangible property is attributable. Dividends 
will be deemed to be derived first out of earnings and profits 
of the treaty-benefited trade or business, and then out of 
other earnings and profits. Interest income may be allocated 
under any reasonable method consistently applied. A method that 
conforms to U.S. principles for expense allocation will be 
considered a reasonable method.

    Example 3. Americair is a corporation resident in the 
United States that operates an international airline. BulSub is 
a wholly-owned subsidiary of Americair resident in Bulgaria. 
BulSub operates a chain of hotels in Bulgaria that are located 
near airports served by Americair flights. Americair frequently 
sells tour packages that include air travel to Bulgaria and 
lodging at BulSub 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 BulSub's business does 
not form a part of Americair's business. However, BulSub'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 BulSub owns an office building in Bulgaria instead of a 
hotel chain. No part of Americair's business is conducted 
through the office building. BulSub'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 
BulHolding, a corporation resident in Bulgaria. BulHolding is a 
holding company that is not engaged in a trade or business. 
BulHolding owns all the shares of three corporations that are 
resident in Bulgaria: BulFlower, BulLawn, and BulFish. 
BulFlower distributes USFlower flowers under the USFlower 
trademark in Bulgaria. BulLawn markets a line of lawn care 
products in Bulgaria under the USFlower trademark. In addition 
to being sold under the same trademark, BulLawn and BulFlower 
products are sold in the same stores and sales of each 
company's products tend to generate increased sales of the 
other's products. BulFish imports fish from the United States 
and distributes it to fish wholesalers in Bulgaria. For 
purposes of paragraph 4, the business of BulFlower forms a part 
of the business of USFlower, the business of BulLawn is 
complementary to the business of USFlower, and the business of 
BulFish 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 (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 (b) states that the trade or business 
carried on in the State of residence, under these 
circumstances, must be substantial in relation to the activity 
in the State of source. The substantiality requirement is 
intended to prevent a narrow case of treaty-shopping abuses in 
which a company attempts to qualify for benefits by engaging in 
de minimis connected business activities in the treaty country 
in which it is resident (i.e., activities that have little 
economic cost or effect with respect to the company business as 
a whole).
    The determination of substantiality is made based upon all 
the facts and circumstances and takes into account the 
comparative sizes of the trades or businesses in each 
Contracting State, the nature of the activities performed in 
each Contracting State, and the relative contributions made to 
that trade or business in each Contracting State.
    The determination in subparagraph (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 4, 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.
    The application of the substantiality requirement only to 
income from related parties focuses only on potential abuse 
cases, and does not hamper certain other kinds of non-abusive 
activities, even though the income recipient resident in a 
Contracting State may be very small in relation to the entity 
generating income in the other Contracting State. For example, 
if a small U.S. research firm develops a process that it 
licenses to a very large, unrelated, pharmaceutical 
manufacturer in Bulgaria, the size of the U.S. research firm 
would not have to be tested against the size of the 
manufacturer. Similarly, a small U.S. bank that makes a loan to 
a very large unrelated company operating a business in Bulgaria 
would not have to pass a substantiality test to receive treaty 
benefits under paragraph 4.
    Subparagraph 4(c) provides special attribution rules for 
purposes of applying the substantive rules of subparagraphs (a) 
and (b). These rules apply for purposes of determining whether 
a person meets the requirement in subparagraph (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, and for making the comparison required by 
the ``substantiality'' requirement in subparagraph (b). 
Subparagraph (c) attributes to a person 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 interest or royalty 
income in the context of a so-called ``triangular case.'' The 
paragraph provides special rules applicable to U.S. source 
interest or royalties that are attributable to a permanent 
establishment that a Bulgarian company has in a third state, 
and that are otherwise exempt from taxation in Bulgaria.
    The term ``triangular case'' refers to the use of the 
following structure by a resident of Bulgaria to earn, in this 
case, interest income from the United States. The resident of 
Bulgaria, who is assumed to qualify for benefits under one or 
more of the provisions of Article 21 (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 Bulgarian 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 Bulgarian resident. 
Therefore, the income earned on those loans, absent the 
provisions of paragraph 5, may be entitled to a reduced rate of 
U.S. withholding tax under the Convention. Under a current 
Bulgarian income tax treaty with the host jurisdiction of the 
permanent establishment, the income of the permanent 
establishment is exempt from Bulgarian tax. Alternatively, 
Bulgaria may choose to exempt the income of the permanent 
establishment from Bulgarian income tax. Thus, the interest 
income is subject to a reduced rate of U.S. tax, is subject to 
little tax in the host jurisdiction of the permanent 
establishment, and is exempt from Bulgarian tax.
    Because 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, the paragraph 
only applies with respect to U.S. source interest or royalties 
that are attributable to a third-jurisdiction permanent 
establishment of a Bulgarian resident.
    Paragraph 5 replaces the otherwise applicable rules in the 
Convention for interest and royalties with a 15 percent 
withholding tax for interest and royalties if the actual tax 
paid on the income in the third state is less than 60 percent 
of the tax that would have been payable in Bulgaria if the 
income were earned in Bulgaria by the enterprise and were not 
attributable to the permanent establishment in the third state.
    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 interest (as defined in Article 11 (Interest)), 
paragraph 5 will not apply if the interest 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. In the 
case of royalties (as defined in Article 12 (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.

Paragraph 6

    Paragraph 6 provides that a resident of one of the States 
that is not entitled to the benefits of the Convention as a 
result of paragraphs 2 through 4 still may be granted benefits 
under the Convention at the discretion of the competent 
authority of the State from which benefits are claimed. Under 
paragraph 6, that competent authority will determine whether 
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 6.
    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 4. 
Further, the competent authority may establish conditions, such 
as setting time limits on the duration of any relief granted.
    For purposes of implementing paragraph 6, 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 the resident 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 paragraph 3 of Article 22, but it does not 
meet any of the objective tests of this Article, it may apply 
to the U.S. competent authority for discretionary relief.

Paragraph 7

    Paragraph 7 defines several key terms for purposes of 
Article 21. Each of the defined terms is discussed above in the 
context in which it is used.

                ARTICLE 22 (RELIEF FROM DOUBLE TAXATION)

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

Paragraph 1

    Paragraph 1 provides that Bulgaria will provide relief from 
double taxation through a mixture of the credit and exemption 
methods.
    Subparagraph 1(a) states the general rule that Bulgaria 
will exempt income derived by a resident if the income may be 
taxed in the United States in accordance with the Convention. 
Subparagraph 1(c), permits Bulgaria to include the income 
corresponding to the U.S. tax in the resident's tax base in 
calculating the Bulgarian tax on the remaining income of the 
resident. This rule provides for ``exemption with 
progression.'' Under subparagraph 1(b), Bulgaria provides for a 
tax credit rather than an exemption with respect to limited 
classes of income. If the income may be taxed by the United 
States under the provisions of Article 10 (Dividends), Article 
11 (Interest), or Article 12 (Royalties), Bulgaria will relieve 
double taxation by allowing a credit against Bulgarian tax in 
an amount equal to the tax paid in the United States on such 
income, but limited to the amount of Bulgarian tax attributable 
to such dividends, interest, and royalty income.

Paragraph 2

    The United States agrees, in paragraph 2, to allow to its 
citizens and residents a credit against U.S. tax for income 
taxes paid or accrued to Bulgaria. Paragraph 2 also provides 
that Bulgaria's covered taxes are income taxes for U.S. 
purposes. This provision is based on the Treasury Department's 
review of Bulgaria's laws.
    Subparagraph (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 
Bulgaria 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 Bulgaria on the profits out of which the 
dividends are considered paid.
    The credits allowed under paragraph 2 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 3

    Paragraph 3 provides a re-sourcing rule for gross income 
covered by paragraph 2. Paragraph 3 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 Bulgaria when the 
Convention assigns to Bulgaria primary taxing rights over an 
item of gross income.
    Accordingly, if the Convention allows Bulgaria 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 
Bulgaria for U.S. foreign tax credit purposes. In the case of a 
U.S.-owned foreign corporation, however, section 904(h)(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(h)(10) generally applies the foreign tax credit 
limitation separately to re-sourced income. Furthermore, the 
paragraph 3 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 paragraph 3.

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 Bulgaria. 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 Bulgaria 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 Bulgaria who is not a U.S. 
citizen. The provisions of paragraph 4 ensure that Bulgaria 
does not bear the cost of U.S. taxation of its citizens who are 
residents of Bulgaria.
    Subparagraph (a) provides, with respect to items of income 
from sources within the United States, special credit rules for 
Bulgaria. 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 Bulgaria who is not a 
U.S. citizen. The tax credit allowed by Bulgaria 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 Bulgaria 
receives portfolio dividends from sources within the United 
States, the foreign tax credit granted by Bulgaria would be 
limited to 10 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.
    Subparagraph 4(b) eliminates the potential for double 
taxation that can arise because subparagraph 4(a) provides that 
Bulgaria need not provide full relief for the U.S. tax imposed 
on its citizens resident in Bulgaria. The subparagraph provides 
that the United States will credit the income tax paid or 
accrued to Bulgaria, 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 Bulgaria in applying subparagraph 4(a).
    Since the income described in paragraph 4(a) generally will 
be U.S. source income, special rules are required to re-source 
some of the income to Bulgaria in order for the United States 
to be able to credit the tax paid to Bulgaria. 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). Subparagraph 3(e) 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 aU.S.-source portfolio dividend 
received by a U.S. citizen resident in Bulgaria. In both 
examples, the U.S. rate of tax on residents of Bulgaria, under 
subparagraph 2(b) of Article 10 (Dividends) of the Convention, 
is 10 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 Bulgaria on its resident (the U.S. 
citizen) is 25 percent (below the U.S. rate), and in example 2, 
the rate imposed on its resident is 40 percent (above the U.S. 
rate).

------------------------------------------------------------------------
                                                Example 1     Example 2
------------------------------------------------------------------------
Subparagraph (a)
U.S. dividend declared......................       $100.00       $100.00
Notional U.S. withholding tax (Article               10.00         10.00
 10(2)(b))..................................
Taxable income in Bulgaria..................        100.00        100.00
Bulgaria tax before credit..................         25.00         40.00
Less: tax credit for notional U.S.                   10.00         10.00
 withholding tax............................
Net post-credit tax paid to Bulgaria........         15.00         30.00
------------------------------------------------------------------------
Subparagraphs (b) and (c)
U.S. pre-tax income.........................       $100.00       $100.00
U.S. pre-credit citizenship tax.............         35.00         35.00
Notional U.S. withholding tax...............         10.00         10.00
U.S. tax eligible to be offset by credit....         25.00         25.00
Tax paid to Bulgaria........................         15.00         30.00
Income re-sourced from U.S. to foreign               42.86         71.43
 source (see below).........................
U.S. pre-credit tax on re-sourced income....         15.00         25.00
U.S. credit for tax paid to Bulgaria 15.00
 25.00......................................
Net post-credit U.S. tax....................         10.00          0.00
Total U.S. tax..............................         20.00         10.00
------------------------------------------------------------------------



    In both examples, in the application of subparagraph (a), 
Bulgaria credits a 10 percent U.S. tax against its residence 
tax on the U.S. citizen. In the first example, the net tax paid 
to Bulgaria after the foreign tax credit is $15.00; in the 
second example, it is $30.00. In the application of 
subparagraphs (b) and (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 $10.00, 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 Bulgaria may be claimed is $25 ($35 U.S. tax minus $10 
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 Bulgaria, an appropriate amount of the income must be 
re-sourced to Bulgaria under subparagraph (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 Bulgaria was $15. For 
this amount to be creditable against U.S. tax, $42.86 ($15 tax 
divided by 35 percent U.S. tax rate) must be resourced to 
Bulgaria. There is a net U.S. tax of $10 due after credit ($25 
U.S. tax eligible to be offset by credit, minus $15 tax paid to 
Bulgaria). Thus, in example 1, there is a total of $20 in U.S. 
tax ($10 U.S. withholding tax plus $10 residual U.S. tax).
    In example 2, the tax paid to Bulgaria was $30, but, 
because the United States subtracts the U.S. withholding tax of 
$10 from the total U.S. tax of $35, only $25 of U.S. taxes may 
be offset by taxes paid to Bulgaria. Accordingly, the amount 
that must be resourced to Bulgaria is limited to the amount 
necessary to ensure a U.S. foreign tax credit for $25 of tax 
paid to Bulgaria, or $71.43 ($25 tax paid to Bulgaria divided 
by 35 percent U.S. tax rate). When the tax paid to Bulgaria is 
credited against the U.S. tax on this re-sourced income, there 
is no residual U.S. tax ($25 U.S. tax minus $30 tax paid to 
Bulgaria, subject to the U.S. limit of $25). Thus, in example 
2, there is a total of $10 in U.S. tax ($10 U.S. withholding 
tax plus $0 residual U.S. tax). Because the tax paid to 
Bulgaria was $30 and the U.S. tax eligible to be offset by 
credit was $25, 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 3 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 5, 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 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 more burdensome than 
the taxes and connected requirements imposed upon a national of 
that other State in the same circumstances. The OECD Model 
language would prohibit taxation that is ``other than or more 
burdensome'' than that imposed on U.S. persons. This Convention 
omits the reference to taxation that is ``other than'' that 
imposed on U.S. persons because the only relevant question 
under this provision should be whether the requirement imposed 
on a national of the other Contracting State is more 
burdensome. A requirement may be different from the 
requirements imposed on U.S. nationals without being more 
burdensome.
    The term ``national'' in relation to a Contracting State is 
defined in subparagraph 1(l) 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 Bulgaria as a national of 
Bulgaria 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 Bulgaria 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 Bulgaria who are not United States 
residents. Thus, for example, Article 23 would not entitle a 
national of Bulgaria 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 Bulgaria is subject to U.S. tax only on income 
that is attributable to the permanent establishment, while a 
U.S. corporation engaged in the same activities is taxable on 
its worldwide income is not, in itself, a sufficient difference 
to provide different treatment for the permanent establishment. 
There are cases, however, where the two enterprises would not 
be similarly situated and differences in treatment may be 
warranted. For instance, it would not be a violation of the 
non-discrimination protection of paragraph 2 to require the 
foreign enterprise to provide information in a reasonable 
manner that may be different from the information requirements 
imposed on a resident enterprise, because information may not 
be as readily available to the Internal Revenue Service from a 
foreign as from a domestic enterprise. Similarly, it would not 
be a violation of paragraph 2 to impose penalties on persons 
who fail to comply with such a requirement (see, e.g., sections 
874(a) and 882(c)(2)). Further, a determination that income and 
expenses have been attributed or allocated to a permanent 
establishment in conformity with the principles of Article 7 
(Business Profits) implies that the attribution or allocation 
was not discriminatory.
    Section 1446 of the Code imposes on any partnership with 
income that is effectively connected with a U.S. trade or 
business the obligation to withhold tax on amounts allocable to 
a foreign partner. In the context of the Convention, this 
obligation applies with respect to a share of the partnership 
income of a partner resident in Bulgaria, and attributable to a 
U.S. permanent establishment. There is no similar obligation 
with respect to the distributive shares of U.S. resident 
partners. It is understood, however, that this distinction is 
not a form of discrimination within the meaning of paragraph 2 
of the Article. No distinction is made between U.S. and non-
U.S. partnerships, since the law requires that partnerships of 
both U.S. and non-U.S. domicile withhold tax in respect of the 
partnership shares of non-U.S. partners. Furthermore, in 
distinguishing between U.S. and non-U.S. partners, the 
requirement to withhold on the non-U.S. but not the U.S. 
partner's share is not discriminatory taxation, but, like other 
withholding on nonresident aliens, is merely a reasonable 
method for the collection of tax from persons who are not 
continually present in the United States, and as to whom it 
otherwise may be difficult for the United States to enforce its 
tax jurisdiction. If tax has been over-withheld, the partner 
can, as in other cases of over-withholding, file for a refund.

Paragraph 3

    Paragraph 3 makes clear that the provisions of paragraphs 1 
and 2 do 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 Bulgaria 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 
Bulgaria 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 4

    Paragraph 4 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 4, 
however, does not require a Contracting State to give non-
residents more favorable treatment than it gives to its own 
residents. Consequently, a Contracting State does not have to 
allow non-residents a deduction for items that are not 
deductible under its domestic law (for example, expenses of a 
capital nature).
    The term ``other disbursements'' is understood to include a 
reasonable allocation of executive and general administrative 
expenses, research and development expenses and other expenses 
incurred for the benefit of a group of related persons that 
includes the person incurring the expense.
    An exception to the rule of paragraph 4 is provided for 
cases where the provisions of paragraph 1 of Article 9 
(Associated Enterprises), paragraph 7 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 7 of Article 11 would include the denial 
or deferral of certain interest deductions under Code section 
163(j).
    Paragraph 4 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 7 of this Article, the nondiscrimination 
provisions apply to all taxes levied in both Contracting 
States, at all levels of government. Thus, this provision may 
be relevant for both States. Bulgaria may have capital taxes 
and in the United States such taxes frequently are imposed by 
local governments.

Paragraph 5

    Paragraph 5 requires that a Contracting State not impose 
more burdensome taxation or connected requirements on an 
enterprise of that State that is wholly or partly owned or 
controlled, directly or indirectly, by one or more residents of 
the other Contracting State than the taxation or connected 
requirements that it imposes on other similar enterprises of 
that first-mentioned Contracting State. For this purpose it is 
understood that ``similar'' refers to similar activities or 
ownership of the enterprise.
    This rule, like all non-discrimination provisions, does not 
prohibit differing treatment of entities that are in differing 
circumstances. Rather, a protected enterprise is only required 
to be treated in the same manner as other enterprises that, 
from the point of view of the application of the tax law, are 
in substantially similar circumstances both in law and in fact. 
The taxation of a distributing corporation under section 367(e) 
on an applicable distribution to foreign shareholders does not 
violate paragraph 5 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 
5 of the Article. If a corporation elects to be an S 
corporation, it is generally not subject to income tax and the 
shareholders take into account their pro rata shares of the 
corporation's items of income, loss, deduction or credit. (The 
purpose of the provision is to allow an individual or small 
group of individuals the protections of conducting business in 
corporate form while paying taxes at individual rates as if the 
business were conducted directly.) A nonresident alien does not 
pay U.S. tax on a net basis, and, thus, does not generally take 
into account items of loss, deduction or credit. Thus, the S 
corporation provisions do not exclude corporations with 
nonresident alien shareholders because such shareholders are 
foreign, but only because they are not net-basis taxpayers. 
Similarly, the provisions exclude corporations with other types 
of shareholders where the purpose of the provisions cannot be 
fulfilled or their mechanics implemented. For example, 
corporations with corporate shareholders are excluded because 
the purpose of the provision to permit individuals to conduct a 
business in corporate form at individual tax rates would not be 
furthered by their inclusion.
    Finally, it is understood that paragraph 5 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 6

    Paragraph 6 of the Article confirms that no provision of 
the Article will prevent either Contracting State from imposing 
either the branch profits tax described in paragraph 8 of 
Article 10 (Dividends) or the branch-level interest tax 
described in paragraph 9 of Article 11 (Interest).

Paragraph 7

    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 paragraph 5(a) of Article 1. Thus, for example, a 
U.S. citizen who is a resident of Bulgaria 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 paragraph 1(k) of Article 3 (General 
Definitions).

Paragraph 1

    This paragraph provides that where a resident of a 
Contracting State considers that the actions of one or both 
Contracting States will result in taxation that is not in 
accordance with the Convention he may present his case to the 
competent authority of either Contracting State. This rule is 
more generous than in most treaties, which generally allow 
taxpayers to bring competent authority cases only to the 
competent authority of their country of residence, or citizen-
ship/nationality. Under this more generous rule, a U.S. 
permanent establishment of a corporation resident in the treaty 
partner 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 Bulgarian 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 Payments, 
Annuities, Alimony, and Child Support).
    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 Bulgaria. See Rev. Proc. 
2006-54, 2006-2 C.B. 1035, Section 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. Under Bulgarian law, a taxpayer may 
secure payment of any tax due (for example, using a letter of 
credit) and need not pay the entire amount of tax due until the 
competent authorities resolve the case, while under U.S. law 
with respect to U.S. initiated adjustments the United States 
generally will postpone further administrative action with 
respect to the issues under competent authority consideration. 
See Rev. Proc. 2006-54, 2006-2 C.B. 1035, Section 7.01.
    Paragraph 10 of the Protocol to the Convention sets forth 
two additional clarifications to the application of paragraph 2 
of Article 24. First, the Protocol notes that an agreement 
reached would not affect any court proceedings or any final 
court decisions or final tax assessment acts. This provision of 
the paragraph is intended to address certain aspects of the 
relationship of mutual agreement procedures and judicial or 
assessment proceedings in Bulgaria.
    Under Bulgarian law, a taxpayer may begin court proceedings 
either before or after it has made a request for assistance 
under this Article. The Protocol confirms that Bulgarian 
judicial proceedings involving mutual agreement procedure 
issues in question will not be inhibited merely by the 
initiation of a request for competent authority assistance. 
Moreover, any final judicial determination involving mutual 
agreement procedure issues may be set aside only if the 
requirements under Bulgarian law for revision or repeal of 
final acts are fulfilled. Similarly, if the Bulgarian revenue 
authority has finalized its tax assessment, irrespective of any 
judicial activity, a mutual agreement procedure cannot change 
that assessment unless the requirements under Bulgarian law for 
revision or repeal of final acts are fulfilled.
    Under the Bulgarian law for revision or repeal of final 
acts, an assessment may be changed based on new information. 
The Treasury Department understands that Bulgaria will 
interpret broadly what constitutes ``new information.'' For 
example, if an examination in Bulgaria is completed and closed, 
the Bulgarian competent authority may nonetheless accept a 
request for assistance based on new information, such as an 
adjustment in the United States.
    Second, paragraph 10 of the Protocol notes that if an 
examination is completed and closed (and the subject of the 
mutual agreement procedure request is not a matter pending 
before a court or for which a settlement or court decision has 
been reached) in a Contracting State, that Contracting State's 
competent authority may nonetheless accept a request for 
assistance if an adjustment causing double taxation is made in 
the other Contracting State. This provision of the Protocol 
confirms that the Bulgarian competent authority can accept a 
mutual agreement procedure request based upon a US-initiated 
adjustment and can subsequently implement any resulting 
competent authority agreement, so long as the issue that is the 
subject of the mutual agreement procedure request is neither an 
issue presented to and pending before a Bulgarian court, nor 
one for which a Bulgarian judicial decision or litigation 
settlement has been concluded.

Paragraph 3

    Paragraph 3 authorizes the competent authorities to resolve 
difficulties or doubts that may arise as to the application or 
interpretation of the Convention. The paragraph includes a non- 
exhaustive list of examples of the kinds of matters about which 
the competent authorities may reach agreement. This list is 
purely illustrative; it does not grant any authority that is 
not implicitly present as a result of the introductory sentence 
of paragraph 3.
    The competent authorities may, for example, agree to the 
same allocation of income, deductions, credits or allowances 
between an enterprise in one Contracting State and its 
permanent establishment in the other or between related 
persons. These allocations are to be made in accordance with 
the arm's length principle underlying Article 7 (Business 
Profits) and Article 9 (Associated Enterprises). Agreements 
reached under these subparagraphs may include agreement on a 
methodology for determining an appropriate transfer price, on 
an acceptable range of results under that methodology, or on a 
common treatment of a taxpayer's cost sharing arrangement.
    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, the characterization of persons, 
the application of source rules to particular items of income, 
or the meaning of a term. They also may agree as to advance 
pricing arrangements.
    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 Bulgaria. 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 authorizes the competent authorities to 
increase any dollar amounts referred to in the Convention to 
reflect economic and monetary developments. Under the 
Convention, this refers only to Article 16 (Entertainers and 
Sportsmen); Article 19 (Students, Trainees, Teachers and 
Researchers) separately instructs the competent authorities to 
adjust the exemption amount for students and trainees in 
accordance with specified guidelines. The rule under paragraph 
4 is intended to operate as follows: if, for example, after the 
Convention has been in force for some time, inflation rates 
have been such as to make the $15,000 exemption threshold for 
entertainers unrealistically low in terms of the original 
objectives intended in setting the threshold, the competent 
authorities may agree to a higher threshold without the need 
for formal amendment to the treaty and ratification by the 
Contracting States. This authority can be exercised, however, 
only to the extent necessary to restore those original 
objectives. This provision can be applied only to the benefit 
of taxpayers (i.e., only to increase thresholds, not to reduce 
them).

Paragraph 5

    Paragraph 5 provides that the competent authorities may 
communicate with each other for the purpose of reaching an 
agreement. This makes clear that the competent authorities of 
the two Contracting States may communicate without going 
through diplomatic channels. Such communication may be in 
various forms, including, where appropriate, through face-to-
face meetings of representatives of the competent authorities.

Treaty termination in relation to competent authority dispute 
        resolution

    A case may be raised by a taxpayer after the Convention has 
been terminated with respect to a year for which the Convention 
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 25 (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 paragraph 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 may be relevant for 
carrying out the provisions of the Convention or the domestic 
laws of the United States or of Bulgaria concerning taxes of 
every kind applied at the national level. This language 
incorporates the standard in 26 U.S.C. section 7602 which 
authorizes the IRS to examine ``any books, papers, records, or 
other data which may be relevant or material.'' (Emphasis 
added.) In United States v. Arthur Young & Co., 465 U.S. 805, 
814 (1984), the Supreme Court stated that the language ``may 
be'' reflects Congress's express intention to allow the IRS to 
obtain ``items of even potential relevance to an ongoing 
investigation, without reference to its admissibility.'' 
(Emphasis in original.) However, the language ``may be'' would 
not support a request in which a Contracting State simply asked 
for information regarding all bank accounts maintained by 
residents of that Contracting State in the other Contracting 
State, or even all accounts maintained by its residents with 
respect to a particular bank.
    Exchange of information with respect to each State's 
domestic law is authorized to the extent that taxation under 
domestic law is not contrary to the Convention. Thus, for 
example, information may be exchanged with respect to a covered 
tax, even if the transaction to which the information relates 
is a purely domestic transaction in the requesting State and, 
therefore, the exchange is not made to carry out the 
Convention. An example of such a case is provided in the OECD 
Commentary: a company resident in the United States and a 
company resident in Bulgaria 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 
Bulgaria, 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 Bulgaria, 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 Bulgaria, 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 Bulgaria 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 2

    Paragraph 2 provides that the requesting State may specify 
the form in which information is to be provided (e.g., 
depositions of witnesses and authenticated copies of original 
documents). The intention is to ensure that the information may 
be introduced as evidence in the judicial proceedings of the 
requesting State. The requested State should, if possible, 
provide the information in the form requested to the same 
extent that it can obtain information in that form under its 
own laws and administrative practices with respect to its own 
taxes.

Paragraph 3

    Paragraph 3 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 appeals in relation to, the taxes covered by 
the Convention. The information must be used by these persons 
in connection with the specified functions. Information may 
also be disclosed to legislative bodies, such as the tax-
writing committees of Congress and the Government 
Accountability Office, engaged in the oversight of the 
preceding activities. Information received by these bodies must 
be for use in the performance of their role in overseeing the 
administration of U.S. tax laws. Information received may be 
disclosed in public court proceedings or in judicial decisions.

Paragraph 4

    Paragraph 4 provides that the obligations undertaken in 
paragraphs 1, 2, and 3 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 4 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 5

    Paragraph 5 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 
4(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 4 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 6

    Paragraph 6 provides that a Contracting State may not 
decline to provide information because that information is held 
by financial institutions, nominees or persons acting in an 
agency or fiduciary capacity. Thus, paragraph 6 would 
effectively prevent a Contracting State from relying on 
paragraph 4 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. This paragraph also requires the disclosure of information 
regarding the beneficial owner of an interest in a person, such 
as the identity of a beneficial owner of bearer shares.

Treaty efective dates and termination in relation to exchange of 
        information

    Once the Convention is in force, the competent authority 
may seek information under the Convention with respect to a 
year prior to the entry into force of the Convention. Even 
though no Convention was in effect during the years in which 
the transaction at issue occurred, the exchange of information 
provisions of the Convention shall have effect from the date of 
entry into force of the Convention without regard to the 
taxable period to which the matter relates. In that case, the 
competent authorities have available to them the full range of 
information exchange provisions afforded under this Article. 
Paragraph 11 of the Protocol, regarding Article 27 (Entry into 
Force), confirms this understanding with respect to the 
effective date of the Article.
    A tax administration may also seek information with respect 
to a year for which a treaty was in force after the treaty has 
been terminated. In such a case the ability of the other tax 
administration to act is limited. The treaty no longer provides 
authority for the tax administrations to exchange confidential 
information. They may only exchange information pursuant to 
domestic law or other international agreement or arrangement.

     ARTICLE 26 (MEMBERS OF DIPLOMATIC MISSIONS AND CONSULAR POSTS)

    This Article confirms that any fiscal privileges to which 
diplomatic or consular officials are entitled under general 
provisions of international law or under special agreements 
will apply notwithstanding any provisions to the contrary in 
the Convention. The agreements referred to include any 
bilateral agreements, such as consular conventions, that affect 
the taxation of diplomats and consular officials and any 
multilateral agreements dealing with these issues, such as the 
Vienna Convention on Diplomatic Relations and the Vienna 
Convention on Consular Relations. The U.S. generally adheres to 
the latter because its terms are consistent with customary 
international law.
    The Article does not independently provide any benefits to 
diplomatic agents and consular officers. Article 18 (Government 
Service) does so, as do Code section 893 and a number of 
bilateral and multilateral agreements. In the event that there 
is a conflict between the Convention and international law or 
such other treaties, under which the diplomatic agent or 
consular official is entitled to greater benefits under the 
latter, the latter laws or agreements shall have precedence. 
Conversely, if the Convention confers a greater benefit than 
another agreement, the affected person could claim the benefit 
of the tax treaty.Pursuant to subparagraph 5(b) of Article 1, 
the saving clause of paragraph 4 of Article 1 (General Scope) 
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 Contracting States shall 
notify each other, through diplomatic channels, when their 
respective requirements for the entry into force of the 
Convention have been satisfied. The Convention shall enter into 
force on the date of receipt of the later of these 
notifications.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

    The date on which a Convention enters into force is not 
necessarily the date on which its provisions take effect. 
Paragraph 2 contains rules that determine when the provisions 
of the Convention will have effect.
    Under paragraph 2(a), the Convention will have effect with 
respect to taxes withheld at source (principally dividends, 
interest and royalties) for amounts paid or credited on or 
after the first day of January in the calendar year following 
the date on which the Convention enters into force. For 
example, if instruments of ratification are exchanged on April 
25th of year 1, the withholding rates specified in paragraph 2 
of Article 10 (Dividends) would be applicable to any dividends 
paid or credited on or after January 1 of year 2.
    For all other taxes, paragraph 2(b) specifies that the 
Convention will have effect for any taxable period beginning on 
or after January 1 of the year following entry into force.
    As discussed under Article 25 (Exchange of Information), 
the powers afforded under that article apply retroactively to 
taxable periods preceding entry into 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. For example, if written notice of 
termination is given through the diplomatic channel not later 
than June 30th of calendar year 1, the provisions of the 
Convention will cease to have effect with respect to taxes 
withheld at source on income paid or credited on or after 
January 1st of calendar year 2. For other taxes, the Convention 
will cease to have effect for any taxable period beginning on 
or after January 1st of calendar year 2.
    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.
            X. Annex II.--Responses to Additional Questions 
                        Submitted for the Record


       Responses of Michael Mundaca, Deputy Assistant Secretary 
(International), Office of Tax Policy, U.S. Department of the Treasury 
             to Questions for the Record From Senator Biden

    Question 1. The President's Letter of Transmittal for the proposed 
Iceland Tax Treaty notes that because the existing treaty with Iceland 
from 1975 does not contain a Limitation on Benefits (``LOB'') 
provision, which is intended to prevent so-called treaty shopping, 
there has been ``substantial abuse of the existing Treaty's provisions 
by third country investors.'' See Treaty Doc. 110-17 at III. Please 
describe the evidence upon which this statement is based.

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

    Question 2. Please explain how the LOB provision will be enforced 
against third-country investors that attempt to benefit from the 
treaty's provisions, should the new treaty be ratified. In addition, 
please describe specific enforcement challenges, if any, that the 
United States has faced in the past when attempting to enforce LOB 
provisions in other tax treaties.

    Answer. The Internal Revenue Service has a multipronged approach to 
enforcing compliance with treaty LOB provisions.
    With respect to payments of amounts subject to withholding, such as 
interest, royalties, and dividends, U.S. withholding agents (e.g., 
banks, brokers) are obligated to obtain, from each foreign payee, 
documentation on which the withholding agents can rely to treat a 
payment as made to a foreign person entitled to a reduced rate of 
withholding tax under the treaty. Absent such documentation, 
withholding at 30 percent is required. More specifically, foreign 
taxpayers who derive and beneficially own the payment must complete a 
Form W-8BEN (Certificate of Foreign Status of Beneficial Owner for U.S. 
Tax Withholding) to claim a reduced rate of withholding tax. Part II of 
the W-8BEN is entitled ``Claim of Tax Treaty Benefits.'' On line 9 the 
beneficial owner must identify its country of residence and, if the 
person is not an individual, represent that it meets the LOB article of 
the relevant treaty.
    With respect to claiming treaty benefits other than withholding tax 
reductions, such as a claim that a taxpayer does not have a permanent 
establishment in the United States, the taxpayer must file Form 8833 
(Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b)) 
attached to a Form 1120-F (U.S. Income Tax Return of a Foreign 
Corporation) or Form 1040 NR (U.S. Nonresident Alien Income Tax 
Return). Line 4 of Form 8833 requires the taxpayer to identify the LOB 
provision that the taxpayer relies upon to be eligible to take the 
treaty-based return position.
    In addition, the Internal Revenue Service audits LOB compliance as 
part of its general assessment of whether a foreign taxpayer is 
eligible to claim treaty benefits. The Treasury Department understands 
that the IRS' audit experience indicates that LOB issues most often 
arise in the context of audits of U.S. corporations that makes payments 
of interest, dividends, or royalties to related foreign persons.
    In the end, however, the simple inclusion of a LOB article in a 
treaty may by itself be largely responsible for limiting treaty 
shopping. The 2007 Treasury Report provides evidence that the mere 
inclusion of a comprehensive LOB provision is a deterrent against 
treaty shopping.

    Question 3. As set forth in Article 27(3) of the proposed treaty 
with Iceland, an unusual year-long transition period is provided for 
investors that are entitled to greater benefits under the 1975 treaty 
than the new treaty, during which they can elect to continue to benefit 
from the application of the 1975 treaty, rather than have the new 
treaty's provisions applied to them. Why was this provision included? 
How does this provision benefit the United States? Is this provision 
one that might be included in future treaties?

    Answer. The transition rule coordinating the entry into force of 
the proposed Iceland treaty and the termination of benefits of the 1975 
treaty is not an uncommon practice when an existing treaty is being 
replaced by a new agreement or is being amended by a new protocol. For 
instance, similar provisions were included in the U.S.-Belgium tax 
treaty (signed November 27, 2006), the U.S.-Germany protocol (signed 
June 1, 2006), the U.S.-U.K. tax treaty (signed July 24, 2001), and the 
U.S.-Denmark tax treaty (signed August 19, 1999). In order to reach 
agreement in 2007 with Iceland regarding inclusion of a LOB provision, 
we agreed to this election.

    Question 4. U.S. income tax treaties with Hungary and Poland 
provide an exemption from withholding on cross-border interest payments 
and, as in the case of the 1975 tax treaty with Iceland, these treaties 
do not include an LOB provision. Is the Treasury Department negotiating 
protocols with Hungary and Poland in order to rectify the omission of 
an LOB provision? If not, why not? If so, please describe the status of 
those negotiations.

    Answer. Updating the agreements with Hungary and Poland is a key 
part of the Treasury Department's effort to protect the U.S. tax treaty 
network from abuse. The Treasury Department has had two rounds of 
negotiations with Hungary already in 2008 with the aim of concluding a 
new agreement as soon as possible. The next round of negotiations is 
scheduled for September 2008, and an additional round is also 
scheduled, if necessary, for December 2008.
    As shown in the 2007 Treasury Report, it does not appear that the 
U.S.-Poland tax treaty has yet been extensively exploited by third-
country residents. Nevertheless, the Treasury Department has had 
preliminary discussions with Poland and anticipates continuing those 
discussions in 2008 with the goal of commencing negotiations to 
conclude a new agreement to update the 1976 agreement. The United 
States places a very high priority on bringing the proposed treaty with 
Iceland into force and on concluding as soon as possible negotiations 
with Hungary and Poland.
    Beyond renegotiating the treaties with Hungary and Poland, the 
Treasury Department reviews the current U.S. tax-treaty network on a 
continuing basis to identify deficiencies in existing agreements and 
areas where more beneficial terms for the United States and U.S. 
taxpayers could be negotiated. As part of this process, antitreaty-
shopping provisions are given special scrutiny to ensure that they are 
functioning appropriately. Those treaties with LOB provisions that are 
out of date or need strengthening are given higher priority in the 
Treasury Department's plan for negotiations.

    Question 5. The proposed treaty with Iceland includes special 
antiabuse rules intended to deny benefits in certain circumstances in 
which an Icelandic-resident company earns U.S.-source income 
attributable to a third-country permanent establishment and is subject 
to little or no tax in the third jurisdiction and Iceland. Similar 
antiabuse rules are included in other recent treaties, including the 
proposed Convention with Bulgaria. The U.S. Model Tax Treaty, however, 
does not include rules addressing so-called ``triangular 
arrangements.'' Why? Is this a provision that might be added to the 
U.S. Model Tax Treaty?

    Answer. The Treasury Department's current policy is to incorporate 
the so-called ``triangular rule'' into tax treaties in which the treaty 
partner exempts from tax certain foreign source income such that a tax 
treaty may be used inappropriately in conjunction with certain branch 
structures to exempt fully from tax certain U.S.-source payments. The 
Treasury Department is considering whether it is appropriate to include 
such a rule in the next update of the U.S. Model tax treaty.

    Question 6. The Committee on Taxation of Business Entities of the 
New York City Bar has written to the Committee on Foreign Relations in 
reference to the so-called ``derivative benefits'' test contained in, 
for example, Article 21(3) of the LOB provision in the proposed treaty 
with Iceland. In particular, the Bar's Committee on Taxation of 
Business Entities has stated that they ``believe that there is a need 
for guidance in determining the scope of the dividend payment relief 
under such derivative provisions, due to the uncertainties involved in 
calculating the relevant stock ownership.'' Has the Office of Tax 
Policy considered whether it would be useful to publish guidance on 
this topic?

    Answer. The New York City Bar Association's Committee on Taxation 
of Business Entities, in its May 2008 report (the NYCBA Report), 
suggests that there is need for guidance clarifying how ownership is 
calculated for purposes of the derivative-benefits rule in our recent 
tax treaties. The Office of Tax Policy recognizes the importance of 
providing published guidance with respect to income tax treaties 
generally, and is currently considering this and other recommendations 
made by the NYCBA Report.

    Question 7. Under the U.S. Model Tax Treaty child support payments 
paid to a resident of a treaty country is exempt from tax in either 
country. The proposed treaty with Iceland, however, makes no mention of 
the tax treatment of child support payments. Why is that?

    Answer. The absence of a special rule governing the taxation of 
child support payments in the proposed Iceland treaty means that the 
taxation of such payments would be governed by Article 20 (Other 
Income), which assigns the exclusive right to tax to the country of 
residence of the recipient. During the course of the negotiations, the 
Treasury Department learned that under Iceland's domestic law, most 
child support payments are not subject to tax. Accordingly, leaving the 
treatment of child support payments to Article 20 (Other Income) 
achieves a tax result very similar to the result under the U.S. Model 
rule; that is, the residence country will have the exclusive right to 
tax child support, but such payments are in most cases exempt from tax 
under the domestic laws of both the United States and Iceland.

    Question 8. Why doesn't the proposed treaty with Iceland address 
the tax treatment of cross-border pension contributions?

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

    Question 9. Like the U.S. Model Tax Treaty, the Iceland Treaty 
provides that pension distributions owned by a resident of a 
contracting country are taxable in the recipient's country of 
residence. The U.S. Model Tax treaty, however, contains an exception to 
this provision under which a pension beneficiary's country of residence 
must exempt from tax a pension amount or other similar remuneration 
that would be exempt from tax in the other contracting country where 
the pension fund is established, as if the beneficiary had been a 
resident of that other country. Why doesn't the proposed treaty with 
Iceland contain such an exception?

    Answer. Like other departures from the U.S. Model, the omission in 
the U.S.-Iceland tax treaty of the exemption from tax for pension 
benefits that would be exempt from tax in the source country was the 
result of the negotiation process. Moreover, Iceland had limited 
flexibility in changing by tax treaty its rules for taxing pensions, 
because those rules are technically under Iceland's pension law, not 
its tax law.

    Question 10. The U.S. Model Tax Treaty allows recipients of 
``income, gains, or profits'' from an entity that is fiscally 
transparent under the tax laws of the recipient's residence to enjoy 
the same treaty benefits on that income as they would have if the 
``income, gains, or profits'' had been received by them directly, so 
long as the income coming to them through the entity is treated no 
differently by their resident country than it would have been had it 
been received directly by them. The provision in the Iceland Treaty for 
fiscally transparent entities closely parallels the provision in the 
U.S. Model Tax Treaty. Yet, rather than referring to such entities as 
``fiscally transparent,'' the Iceland Treaty refers instead to entities 
that are either ``a partnership, trust, or estate.'' See Article 1(6). 
Treasury's Technical Explanation makes clear that this is intended to 
include U.S. limited liability companies (``LLCs'') that are treated as 
partnerships or as disregarded entities for U.S. tax purposes, 
including LLCs with only one member. Although the meaning appears to be 
equivalent, why wasn't the phrase ``fiscally transparent'' used in 
Article 1(6)?

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

    Question 11. The Convention Between the United States and the 
Republic of Bulgaria for the avoidance of Double Taxation and the 
Prevention of Fiscal Evasion With Respect to Taxes on Income, with 
accompanying Protocol, was signed on February 23, 2007. Before 
transmitting this treaty to the Senate, however, a Protocol amending 
the 2007 treaty was negotiated with Bulgaria. This Protocol was signed 
on February 26, 2008 and only after its completion, did the executive 
branch transmit the original treaty to the Senate for advice and 
consent. Why was the 2008 Protocol needed? What changed between 
February 2007 and February 2008 to necessitate amending the 2007 
treaty? What is the most important correction made by the 2008 Protocol 
to the underlying treaty?

    Answer. The 2008 Protocol made certain technical corrections to the 
2007 Convention and accompanying Protocol, and addressed features of 
the Bulgarian tax system and treaty network that could result in a 
Bulgarian tax exemption for U.S. source income attributable to offshore 
branches of the Bulgarian company receiving the U.S. source income. To 
address the potential ``double exemption'' issue, the proposed 2008 
Protocol would add a so-called ``triangular rule'' to the LOB provision 
of the proposed treaty, which is the most important addition to be made 
by the 2008 Protocol.

    Question 12. Under the Bulgaria Convention, with limited 
exceptions, the withholding tax on cross-border royalty and interest 
payments would be imposed at a maximum rate of five percent. Under the 
accompanying protocol, the United States and Bulgaria are to reconsider 
source-taxation of interest and royalties arising in Bulgaria and 
beneficially owned by a resident of the United States, at a time that 
is ``consistent with the conclusion of the transition period'' under a 
European Union Council Directive applicable to interest and royalties 
deemed to arise in Bulgaria and beneficially owned by a resident of the 
European Union. The conclusion of the transition period is due to occur 
on December 31, 2014. Please explain the reason for including this 
commitment to reconsider source-taxation of interest and royalties 
arising in Bulgaria and beneficially owned by a resident of the United 
States. Is it fair to say that when you consult, you expect to 
negotiate an amendment to the Bulgaria Convention that would further 
reduce the maximum rate of withholding that can be imposed on cross-
border interest and royalties arising in Bulgaria and beneficially 
owned by a resident of the United States?

    Answer. At the conclusion of the transition period under the 
European Union Council Directive, Bulgaria is expected to adopt rates 
of withholding on cross-border interest and royalties for residents of 
European Union member states that are lower than the rate provided for 
in the proposed treaty. The provision of the 2007 Protocol is intended 
to memorialize the understanding between Bulgaria and the United States 
that the United States will have the opportunity at the conclusion of 
the transition period to negotiate a further protocol to the proposed 
treaty with Bulgaria that could reduce the maximum rate of withholding 
that may be imposed on cross-border interest and royalties arising in 
Bulgaria.

    Question 13. Both the Bulgaria Convention and the Canada Protocol 
include a special rule that broadens the typical definition of a 
``Permanent Establishment'' such that a service enterprise may still be 
deemed to have a Permanent Establishment in a treaty country, even if 
it does not have a fixed place of business in that country (the 
``services country''). See Article 5(8) of the Bulgaria Convention and 
Article 3(2) of the Canada Protocol.

   13A. A number of the terms used in this rule are somewhat 
        ambiguous and although the Technical Explanations for the 
        Bulgaria Convention and the Canadian Protocol help to resolve 
        some of that ambiguity, there is still work to be done. Please 
        describe the steps you are taking with Canada, Bulgaria, and 
        internally to further clarify the application and operation of 
        this provision, including the specific terms you are focused on 
        clarifying. In particular, is work being done to further 
        clarify what constitutes ``presen[ce]'' in the services country 
        and what constitutes a ``connected project''? What about the 
        ``provision of services''? Is this term, for example, intended 
        to include preparatory work or the collection of data from an 
        office in one country in order to provide services in the other 
        country?

    Answer. In preparing the agreed Technical Explanation of the 
proposed Protocol with Canada, the Treasury Department had many 
discussions with Canada regarding the interpretation and application of 
the new rule concerning the taxation of services.
    If the proposed Protocol is approved by the Senate, the Treasury 
Department will continue these discussions with Canada. The Treasury 
Department's discussions with Canada to date have encompassed the 
interpretation of a number of terms, including ``presen[ce]'' in the 
services country, what constitutes ``connected projects,'' and the 
meaning of ``provision of services.'' For example, the Technical 
Explanation to the proposed Protocol clarifies that paragraph 6 of 
Article V (Permanent Establishment) of the existing U.S.-Canada treaty 
applies notwithstanding the new rule for taxation of services. 
Paragraph 6 identifies activities with respect to which a fixed place 
of business will not give rise to a permanent establishment, which 
includes activities that have a preparatory or auxiliary character. 
Accordingly, days spent on preparatory or auxiliary activities shall 
not be taken into account for purposes of applying the services rule 
described in subparagraph 9(b) of Article V.
    The Treasury Department recognizes that additional guidance with 
respect to the services rule included in both the proposed Canada 
Protocol and the Bulgaria Convention is needed to provide more 
certainty to taxpayers, and we welcome further input regarding 
application of the rule.

   13B. Article 14(1) of the Bulgaria Convention, with certain 
        exceptions, sets forth a general rule that if an employee who 
        is a resident of one treaty country (the ``residence country'') 
        is working in the other treaty country (the ``employment 
        country''), his or her salaries, wages, and other remuneration 
        derived from the exercise of employment in that country may be 
        taxed by that country--i.e., the employment country. 
        Notwithstanding this general rule, Article 14(2) of the treaty 
        provides that the remuneration derived by the employee from the 
        exercise of employment in the employment country shall be taxed 
        only by the residence country (and not the employment country) 
        if (1) the employee is present in the employment country for 
        183 days or less in any 12-month period commencing or ending in 
        the taxable year concerned; (2) the remuneration is paid by, or 
        on behalf of, an employer who is not a resident of the 
        employment country; and (3) the remuneration is not ``borne'' 
        by a permanent establishment that the employer has in the 
        employment country. The Canada Protocol has a variation of this 
        provision in Article 10(2), which amends Article XV of the 
        Canada Tax Treaty. In both treaties, the final requirement 
        (i.e., that the remuneration is not ``borne'' by a permanent 
        establishment that the employer has in the employment country), 
        interacts with the special rule expanding the definition of a 
        permanent establishment in a potentially problematic way.
    For example, in the case of the Bulgaria Convention, it appears 
that the salaries, wages, and other remuneration derived by an employee 
performing services through a permanent establishment arising under 
Article 5(8) of the treaty would be subject under Article 14 to being 
taxed by the employment country, even if the other requirements of the 
test in Article 14(2) had been met (i.e., the employee had been present 
in the employment country for less than 183 days during any 12-month 
period commencing or ending in the taxable year concerned and the 
employee's remuneration was paid by an employer who is a resident of 
the other country). Is this correct? If so, the interaction of these 
two provisions would increase the complexities associated with the 
special rule contained in Article 5(8). For example, such a scenario 
would mean that an employer and the relevant employees would need to 
fulfill several tax-related obligations, including obtaining tax 
identification numbers and providing for the withholding of income 
taxes and other taxes as appropriate that would cover the period 
beginning on the first day such services were performed by such 
employee during the affected year. Please explain how the Department 
intends to address the problems presented by this result for taxpayers 
that may not know whether they will be deemed to have a permanent 
establishment under the treaty until perhaps 6 months into the relevant 
12-month period, and will therefore be subject to various taxes, 
including employment taxes, by the services country reaching back to 
the beginning of the relevant 12-month period.

    Answer. It is correct that a permanent establishment arising under 
Article 5(8) of the proposed Bulgaria Convention is a permanent 
establishment for purposes of Article 14 of the Convention, and 
therefore the salaries, wages, and other remuneration of an employee 
borne by a permanent establishment of the employer arising under 
Article 5(8) of the treaty would be subject under Article 14 to being 
taxed by the source country, even if the other requirements of the test 
in Article 14(2) had been met.
    The Treasury Department recognizes that the rule for taxation of 
services in the proposed Canada Protocol raises compliance and 
administrative concerns for companies and their employees. The Treasury 
Department and Internal Revenue Service have met with a number of U.S. 
taxpayers, including professional services firms, to discuss the 
interpretation and application of this rule, focusing on administrative 
issues. The Treasury Department has discussed with Canada and, if the 
proposed Protocol is approved by the Senate, will continue to discuss 
with Canada, possible methods of easing the administrative burden on 
businesses associated with complying with this new rule, the effective 
date of which is delayed until the third taxable year ending after the 
proposed Protocol enters into force. The Technical Explanation to the 
proposed Canada Protocol, the contents of which the Government of 
Canada has subscribed to, provides that ``[t]he competent authorities 
are encouraged to consider adopting rules to reduce the potential for 
excess withholding or estimated tax payments with respect to employee 
wages that may result from the application of [the services rule].''

   13C. A version of this special rule appears in the 2008 OECD 
        draft update to the OECD Model Tax Convention as an alternative 
        services permanent establishment provision. There are, however, 
        a few differences in language between the OECD rule and the one 
        used in the Bulgaria Convention and the Canada Protocol. In 
        particular, the OECD language clarifies that services performed 
        by an individual on behalf of an enterprise may be considered 
        as performed by that enterprise only if the enterprise 
        supervises, directs, or controls the manner in which the 
        services are performed by the individual. The language in the 
        text of the Bulgaria Convention and the Canada Protocol are 
        silent on this point, apparently leaving open the question of 
        whether, and if so, under what circumstances, the use of a 
        subcontractor might give rise to a permanent establishment of a 
        general contractor. Is it Treasury's view that services 
        performed by an individual on behalf of an enterprise may be 
        considered as performed by that enterprise only if the 
        enterprise supervises, directs, or controls the manner in which 
        the services are performed by the individual? Does Canada share 
        this view? Does Bulgaria?

    Answer. For a number of years, the OECD has debated whether to 
include an alternative rule for the taxation of services in the OECD 
Model or its Commentary. The 2008 Update to the OECD Model, released on 
July 18, 2008, includes a version of the services rule as an 
alternative in the Model Commentary. The language of the OECD provision 
does not match in all respects the language of provision included in 
the proposed Bulgaria Convention and the Canada Protocol. For example, 
the language of the Bulgarian and Canadian provision requires that the 
services be provided ``for customers who are either residents of that 
other State or who maintain a permanent establishment in that other 
State.'' That language regarding the provision of services to customers 
is not included in the OECD provision, and thus the issue of whether 
the use of a subcontractor might give rise to a permanent establishment 
is especially important in applying the OECD provision. If the Senate 
approves the proposed the Bulgaria Convention and Canada Protocol, the 
Treasury Department will continue to discuss with Bulgaria and Canada 
the interpretation and application of the version of the rule for 
taxation of services included in our agreements.

   13D. One aspect of the rule in both the Bulgaria Convention 
        and the Canada Protocol that would appear to be difficult to 
        manage is the fact that the 12-month period isn't tied to a 
        fiscal year. Is this something you considered and rejected 
        during the course of negotiations? Is this something that might 
        be considered in the future, should you include this special 
        rule in future treaties?

    Answer. The rule for taxation of services in the proposed 
agreements with Bulgaria and Canada refers to an aggregate of 183 days 
or more in ``any 12-month period'' as opposed to, for example, 183 days 
or more in a fiscal or calendar year. The reference to ``any 12-month 
period'' addresses potential situations in which, for example, work has 
been artificially divided into two separate fiscal years in order to 
avoid meeting the 183-day threshold. For instance, a taxpayer could 
circumvent a threshold based on 183 days in a fiscal year by providing 
services in the other state for the last 5 months of 1 fiscal year and 
the first 5 months of the following fiscal year.
    The Treasury Department recognizes the administrative and 
compliance concerns of companies and their employees regarding the 
rule's reference to ``any 12-month period.'' If the proposed agreements 
with Bulgaria and Canada are approved by the Senate, the Treasury 
Department will continue to discuss the interpretation and application 
of this rule with Bulgaria and Canada in the context of exploring ways 
to alleviate administrative and compliance burdens.
    The inclusion of a rule for taxation of services in the proposed 
agreements with Bulgaria and Canada does not reflect a change in U.S. 
tax treaty policy, and inclusion of such a provision in the U.S. Model 
is not being considered. However, it is a provision that the Treasury 
Department will consider in the context of negotiating a particular 
agreement in exchange for significant concessions in other areas, and 
the inclusion of such a provision in the proposed agreements with 
Bulgaria and Canada was a key element to achieving overall agreements 
that provide benefits to the United States and to U.S. taxpayers. At 
the same time, the Treasury Department recognizes the concerns raised 
by the Joint Committee on Taxation's ``Explanation of Proposed Protocol 
to the Income Tax Treaty between the United States and Canada'' about 
the appropriateness of including a services rule in a tax treaty with a 
developed country.
    In the context of negotiating a particular agreement in the future, 
the Treasury Department may consider referring to an alternative 12-
month period. The Treasury Department welcomes input concerning this 
issue.

    Question 14. Mandatory arbitration was included in the Protocol 
with Canada, but not in the treaty with Iceland or Bulgaria. Please 
explain why. In negotiating future treaties, what are the factors 
considered by Treasury when deciding whether or not to include binding 
arbitration in a new tax treaty or in an amendment to an existing tax 
treaty? Are you currently negotiating mandatory arbitration mechanisms 
with other countries? If so, which countries?

    Answer. The Treasury Department believes that mandatory binding 
arbitration, as an extension of the competent authority process, is an 
effective tool to strengthen the Mutual Agreement Procedure in the U.S. 
treaty network as a whole. Even in the best competent authority 
relationships, there are, on occasion, difficult treaty interpretation 
questions and disputes that arise. The Treasury Department believes 
that the arbitration mechanism included in the proposed agreement with 
Canada will help resolve cases in a timely manner and enhance the 
working relationship of the competent authorities.
    The Treasury Department has been discussing mandatory binding 
arbitration in general terms with our treaty partners, and intends to 
continue to raise inclusion of a mandatory binding arbitration 
provision with our treaty partners in future negotiations. The Treasury 
Department welcomes further input from the Committee concerning the 
factors that should be taken into account when considering whether to 
include an arbitration provision in the context of the negotiation of a 
particular agreement, as well as ways that the arbitration provision in 
future agreements might be improved or varied.

    Question 15. When considering the mandatory arbitration provisions 
in the Belgium and Germany tax treaties, which were approved by the 
Senate last year, the committee focused on, among other things, the 
selection of fair, objective, and independent arbiters. In answer to a 
question for the record regarding your process for selecting arbiters, 
it was noted that the Treasury Department ``expect[s] to have further 
discussions with our treaty partners concerning the [selection of 
arbiters], with a view toward achieving the best balance of the 
concerns expressed and providing to taxpayers an efficient and 
effective resolution of their double taxation.'' Please describe the 
status of such discussions with Belgium and Germany. Does the 
Department expect to have discussions with Canada on this topic as 
well? Specifically, what work has been done to ensure that the United 
States and all three treaty partners will select fair, objective, and 
independent arbiters for service on arbitration boards constituted by 
the mechanisms provided in these treaties?

    Answer. The U.S. competent authority has formally begun discussions 
with Belgium and Germany on a number of procedural matters to ensure 
the effective implementation of the arbitration provision, including 
regarding the qualifications for arbiters, especially those 
qualifications required to ensure that arbiters are sufficiently 
independent. In those discussions, the U.S. competent authority has 
expressed the concerns raised by the committee in its considerations of 
the Belgian and German agreements regarding the selection of Government 
employees as arbiters. We hope that similar discussions with Canada 
begin soon. While we do not yet have formal agreements with any of 
these treaty partners, they understand and agree with the need for 
fair, objective, and independent arbitration boards.

    Question 16. The Canada Protocol, as in the case of the Belgium and 
Germany tax treaties, does not identify the procedural rules that will 
be used by arbitration boards constituted in accordance with the 
mandatory arbitration provision included in each treaty. In answer to a 
question for the record on this topic in relation to the Belgium and 
Germany tax treaties, the Treasury Department noted that ``after 
studying the details of the [procedural] rules commonly used in 
commercial arbitration, we concluded that most of these rules relate to 
evidentiary procedures not relevant to the simplified arbitration 
format proposed in the agreements with Belgium and Germany, primarily 
because the decision of the arbitration board is to be based upon a 
record rather than a presentation of evidence.'' Has the Treasury 
Department had discussions with Canada, Belgium, and Germany regarding 
what procedural rules would be appropriate for the arbitration format 
provided for in these treaties? In particular, has there been any 
discussion regarding conflict of interest rules that might apply to 
arbiters?

    Answer. The U.S. competent authority has formally begun discussions 
with Belgium and Germany, and informally with Canada, on a number of 
procedural matters to ensure the effective implementation of the 
arbitration provision. The objective of these discussions is to have 
the procedures in place with respect to Belgium and Germany no later 
than December 31, 2008. As part of the discussions with Belgium and 
Germany, the U.S. competent authority has also begun discussing the 
need for conflict-of-interest rules to govern arbiters. For example, 
the U.S. competent authority has discussed whether safeguards might be 
built into the necessary procurement arrangements between the United 
States and the arbiter. While the U.S. competent authority does not yet 
have formal agreements with any of these treaty partners, they 
understand and agree with the need for fair, objective, and independent 
arbitration boards.

    Question 17. The Committee Report on the Germany and Belgium 
treaties raised certain concerns regarding the mandatory arbitration 
mechanism, including concerns regarding treaty interpretation and the 
selection of arbiters. Other Members have indicated related concerns 
regarding these provisions. None of these are addressed in the Canada 
Protocol arbitration provision, but presumably that is because the 
Canada Protocol was already negotiated when these concerns were raised. 
Can you, however, confirm that these concerns will be considered and 
addressed in future tax treaties with similar arbitration mechanisms?

    Answer. The arbitration provision in the proposed Protocol with 
Canada was already negotiated at the time the Senate considered the 
agreements with Germany and Belgium in 2007. It is for this reason that 
the concerns expressed by the Committee on the agreements with Germany 
and Belgium are not reflected in the proposed Canada Protocol.
    The Treasury Department greatly appreciates the input received from 
the committee on several aspects of the German and Belgian arbitration 
provisions, and similarly with the Canadian Protocol. The committee's 
concerns have been and will continue to be considered in any 
arbitration negotiations the Treasury Department conducts.

    Question 18. The exchange of notes between the United States and 
Canada that accompanies the Canada Protocol includes many of the 
details that would govern the binding arbitration mechanism to be 
included in the treaty. Among other things, the notes make clear that 
the arbitration mechanism would only apply to certain articles in the 
treaty, which are listed, unless otherwise agreed to by the parties.

   18A. How were the articles to which arbitration applies, 
        selected?

    Answer. The Treasury Department believes that mandatory binding 
arbitration, as an extension of the competent authority process, is an 
effective tool to strengthen the Mutual Agreement Procedure in the U.S. 
treaty network as a whole. However, the scope of an arbitration 
provision in a particular agreement is a matter that must be negotiated 
with the treaty partner. Some countries may be willing to cover only 
specific articles in the treaty. It should be noted that while the 
mandatory binding arbitration provision in the proposed Canada Protocol 
is limited to certain articles, other issues are eligible for 
arbitration if the competent authorities agree that the particular case 
is suitable for arbitration.

   18B. Why isn't Article 3 (Definitions) among the articles 
        included in this list?

    Answer. Article III of the existing Canada treaty provides 
definitions and general rules of interpretation for the treaty. 
Paragraph 1 of Article III defines a number of terms for purposes of 
the treaty. Certain other terms are defined in other articles of the 
treaty. Paragraph 2 of Article III provides that, in the case of a term 
not defined in the treaty, the domestic tax law of the Contracting 
State applying the treaty shall control, unless the context in which 
the term is used requires a definition independent of domestic tax law 
or the competent authorities reach agreement on a meaning.
    To the extent that an issue concerning the definition of a term is 
part of a case regarding the application of one or more articles 
explicitly within the scope of the mandatory arbitration provision, 
such definitional issue will be considered during the arbitration 
process.

   18C. If a dispute focuses on a term that is defined in 
        Article 3 and appears in another Article that is within the 
        scope of the arbitration mechanism, would such a dispute be 
        subject to arbitration under the Protocol?

    Answer. To the extent that an issue concerning the definition of a 
term defined in Article III is part of a case regarding the application 
of one or more articles explicitly within the scope of the mandatory 
arbitration provision, such definitional issue will be considered 
during the arbitration process

    Question 19. Article 2(1) of the proposed Canada Protocol addresses 
the issue of so-called ``dual-resident corporations.'' It provides that 
if such a company is created under the laws in force in a treaty 
country but not under the laws in force in the other treaty country, 
the company is deemed to be a resident only of the first treaty 
country. Have you considered whether this rule is equitable, for 
example, in circumstances in which a corporation was organized under 
the laws of the United States many years ago and has long since ceased 
to have significant contacts with the United States, but instead is 
managed and controlled in Canada? Have you considered whether it might 
be appropriate to provide discretion to the Competent Authorities in 
such a case to determine, for example, that the company is in fact a 
resident of Canada?

    Answer. To address abuses of the existing treaty by U.S. companies 
continuing into Canada, the proposed Protocol replaces the existing 
treaty's rule for resolving dual-residency conflicts for corporations 
with an updated rule that is similar to the rule in the U.S. Model. It 
has been a longstanding treaty policy of the United States to place 
significant weight on the place of incorporation when addressing 
questions of dual corporate residence. However, we have included in 
other agreements, for example in our agreement with the United Kingdom 
and the proposed Bulgaria and Iceland agreements, provisions directing 
the Competent Authorities to endeavor to determine for treaty purposes 
the residence of dual resident corporations.

    Question 20. Article 2(2) of the Canada Protocol would amend 
Article IV of the Canada Tax Treaty to include a new paragraph 6 and 7, 
setting forth specific rules for the treatment of certain income, 
profit, or gain derived through or paid by fiscally transparent 
entities. The new paragraph 6 would set forth a ``positive'' rule, 
which identifies scenarios in which ``income, profit or gain shall be 
considered to be derived by a person who is a resident of a Contracting 
State.'' The new paragraph 7 would set forth a ``negative'' rule 
intended to prevent the use of such entities to claim the benefits 
where the investors are not subject to tax on the income in their state 
of residence. In particular, paragraph 7 is aimed largely at curtailing 
the use of certain legal entity structures that include hybrid fiscally 
transparent entities, which, when combined with the selective use of 
debt and equity, may facilitate the allowance of either (1) duplicated 
interest deductions in the United States and Canada, or (2) a single, 
internally generated, interest deduction in one country without 
offsetting interest income in the other country. As noted by the Joint 
Committee on Taxation in its explanation of the Canada Protocol, 
commentators have raised a question as to whether subparagraph 7(b) is 
too broad, because it could prevent legitimate business structures that 
are not engaging in potentially abusive transactions from taking 
advantage of benefits that would otherwise be available to them under 
the treaty. Please explain whether you agree or disagree with the 
assertion that subparagraph 7(b) is overbroad. If so, has there been 
any discussion regarding what might be done to improve the situation? 
In addition, does the Treasury Department expect to include such a rule 
in future tax treaties? If so, has the Treasury Department considered 
alternate versions that might provide for a narrower exception from the 
rule in paragraph 6?

    Answer. Subparagraph 7(b) essentially denies benefits in cases in 
which the residence country treats a payment differently than the 
source country and other conditions are met. The rule is broader than 
an analogous rule in Treasury regulations issued pursuant to section 
894 of the Internal Revenue Code. The Treasury Department is aware that 
the scope of subparagraph 7(b) is potentially overbroad, especially in 
the case of nondeductible payments. The Treasury Department has been 
discussing, and will continue to discuss with Canada, whether to 
address this issue. The Treasury Department does not contemplate 
incorporating such a rule in future tax treaties.

    Question 21. The Treasury Department's Technical Explanation 
provides several examples of the application of subparagraph 7(b) to 
certain legal entity structures. But, the Technical Explanation does 
not provide an example of a payment made by a U.S. domestic reverse 
hybrid entity that is treated as a partnership for Canadian tax 
purposes to one of its owners. Although the partnership example in the 
Technical Explanation should apply reciprocally to a payment treated as 
a dividend for U.S. tax purposes and a partnership distribution for 
Canadian tax purposes, the Technical Explanation does not state so 
explicitly. Can you confirm that this is the case?
    In addition, the Technical Explanation does not include examples 
relating to a deductible interest (or royalty) payment from a hybrid 
partnership entity to one of its owners. In the case of such a payment 
from a Canadian hybrid partnership entity, the U.S. recipient of the 
payment would generally treat it as a payment of interest (or 
royalties) for U.S. tax purposes.\1\ One might expect that subparagraph 
7(b) would not apply in this case because the fiscal transparency of 
the partnership would generally not be relevant for residence-country 
tax purposes, but there is no discussion of this case in the Technical 
Explanation. Can you confirm that this is a reasonable reading of 
subparagraph 7(b)? Also, please clarify whether subparagraph 7(b) 
applies with respect to deductible payments by a domestic reverse 
hybrid partnership entity to one of its Canadian owners.
---------------------------------------------------------------------------
    \1\Under section 707(a) and Treas. Reg. section 1.707-1(a), if a 
partner engages in a transaction with a partnership other than in the 
capacity as a member of the partnership, the transaction is, in 
general, considered as occurring between the partnership and one who is 
not a partner. See Rev. Rul. 73-301, 1973-2 C.B. 215.

    Answer. Page 10 of the agreed Technical Explanation provides an 
example of the application of subparagraph 7(b):
    ``[Assume] in the above example, USCo (as well as other persons) 
are owners of CanCo, a Canadian entity that is considered under 
Canadian tax law to be a corporation that is resident in Canada but is 
considered under U.S. tax law to be a partnership (as opposed to being 
disregarded). Assume that USCo is considered under Canadian tax law to 
have received a dividend from CanCo. Such payment is viewed under 
Canadian tax law as a dividend, but under U.S. tax law is viewed as a 
partnership distribution. In such a case, Canada views USCo as 
receiving income (i.e., a dividend) from an entity that is a resident 
of Canada (CanCo), CanCo is viewed as fiscally transparent under the 
laws of the United States, the residence State, and by reason of CanCo 
being treated as a partnership under U.S. tax law, the treatment under 
U.S. tax law of the payment (as a partnership distribution) is not the 
same as the treatment would be if CanCo were not fiscally transparent 
under U.S. tax law (as a dividend). As a result, subparagraph 7(b) 
would apply to provide that such amount is not considered paid to or 
derived by the U.S. resident.''
    The provisions of subparagraph 7(b) apply reciprocally. Assume, for 
example, that CanCo (as well as other persons) are owners of USCo, a 
U.S entity that is considered under U.S. tax law to be a corporation 
resident in the United States, but is considered under Canadian tax law 
to be a partnership (a so-called ``domestic reverse hybrid''). Assume 
that CanCo is considered under U.S. tax law to have received a dividend 
from USCo. Such payment is viewed under U.S. tax law as a dividend, but 
under Canadian tax law is viewed as a partnership distribution. In such 
a case, the United States views CanCo as receiving income (i.e., a 
dividend) from an entity that is a resident of the United States 
(USCo), USCo is viewed as fiscally transparent under the laws of 
Canada, the residence State, and by reason of USCo being treated as a 
partnership under Canadian tax law, the treatment under Canadian tax 
law of the payment (as a partnership distribution) is not the same as 
the treatment would be if USCo were not fiscally transparent under 
Canadian tax law (as a dividend). As a result, subparagraph 7(b) would 
apply to provide that such amount is not considered paid to or derived 
by the Canadian resident.
    As noted in the agreed Technical Explanation: ``Paragraphs 6 and 7 
apply to determine whether an amount is considered to be derived by (or 
paid to) a person who is a resident of Canada or the United States. If, 
as a result of paragraph 7, a person is not considered to have derived 
or received an amount of income, profit or gain, that person shall not 
be entitled to the benefits of the Convention with respect to such 
amount. Additionally, for purposes of application of the Convention by 
the United States, the treatment of such payments under Code section 
894(c) and the regulations thereunder would not be relevant.'' Thus, 
subparagraph 7(b) applies with respect to deductible payments by a 
domestic reverse hybrid to its Canadian owners.
    Although not specifically addressed in the Technical Explanation, 
the Treasury Department and Canada agree that subparagraph 7(b) does 
not apply to deny benefits to interest and royalty payments by an 
entity that is treated as a partnership by one country and a 
corporation by the other if the treatment of such amount by the country 
of the person deriving the income would be the same if such amount had 
been derived directly by such person (interest or royalties).

    Question 22. Does the Treasury Department intend to formally share 
its Technical Explanation regarding the Bulgaria and Iceland Treaties 
with each country, as a courtesy?

    Answer. As a courtesy, the Treasury Department has sent copies of 
its Technical Explanation to each country. Unlike the Technical 
Explanation to the proposed Canada Protocol, however, the Technical 
Explanations to the proposed Bulgaria and Iceland Conventions have not 
been reviewed by or subscribed to by the relevant country.
                                 ______
                                 

 Responses of Deputy Assistant Secretary Michael Mundaca to Questions 
              Submitted for the Record From Senator Lugar

    Question 1. Please give an overview of current cases that have not 
been resolved and the anticipated case load that would be addressed by 
the Arbitration Provision in the Protocol with Canada, including number 
of cases, length of time unresolved, and country of origin breakdowns.

    Answer. There are currently 192 active cases with Canada. Of those, 
approximately 90 percent are transfer-pricing cases, with the remainder 
involving interpretive issues, such as residency and permanent-
establishment determinations. The Canadian tax authorities initiated 
the adjustment in 85 percent of the cases caused by a transfer pricing 
adjustment.
    Fifty-three of the 192 total cases have been unresolved for over 
two years. Of those 53 cases, the ``oldest'' case is 2,289 days old and 
the ``youngest'' case is 762 days old. Four of the 53 cases involve 
interpretive issues, the oldest of which is 1,657 days and the youngest 
of which is 1085 days.
    We should note that different countries track their outstanding 
competent authority cases differently. For example, concepts such as 
the definition of a case may vary by country. Thus, we have observed 
that where a treaty partner has aggregate information regarding its 
case load with the United States the numbers sometimes notably diverge 
from the numbers used by the United States.

    Question 2. Traditionally, tax treaties agreements have been seen 
as facilitating cross-border trade and investment of multinational 
businesses. However, increasing globalization also affects small 
businesses. Is the current model for U.S. Tax Treaties clear, 
understandable and usable for smaller businesses? Give examples of how 
small business can take advantage of these treaties.

    Answer. The current U.S. Model Tax Treaty and Technical Explanation 
are available on the Treasury Department Web site. The Treaty and 
especially the Technical Explanation are drafted to be as clear and 
understandable as possible, but we recognize that technical 
international tax rules and issues may appear opaque to many taxpayers. 
IRS publications, especially Publication 901 on Tax Treaties, provide 
international tax guidance in less technical terms and may be more 
accessible to individuals who do not have significant tax experience.
    We further recognize that in our increasingly global economy, small 
businesses and individuals may, and perhaps must, address cross-border 
tax issues. Because our tax treaties provide generally uniform and 
clear rules regarding such important issues as withholding tax rates 
and tax jurisdictional thresholds, we think they can be especially 
useful to small businesses and individuals, who may not have access to 
multinational advisors or foreign tax advice. More specifically, tax 
treaties generally allow U.S. businesses to engage in trade in goods 
and services of greater value and duration with foreign clients without 
incurring foreign taxes than would be the case in the absence of 
treaties. Treaties may also facilitate access to foreign skilled 
workers and researchers, and to foreign capital via reduced withholding 
rates.
    We welcome further input from the committee regarding how best to 
serve small businesses in this regard.
    Question 3. Please describe the current U.S. position on reciprocal 
elimination of withholding taxes on cross-border dividends paid between 
a subsidiary and its parent company. Has there been a change in the 
U.S. policy position?

    Answer. The policy of the Treasury Department continues to be that 
the elimination of source-country taxation of dividends should be 
considered only on a case-by-case basis. Such a provision is not part 
of the U.S. Model because we do not believe that it is appropriate to 
include in every treaty. We must consider the interaction of our tax 
system with our treaty partner's, as well as the overall balance of the 
treaty before deciding whether inclusion is appropriate.

                                 

      
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