1. Introduction

In a situation where a tax treaty applies, Art. 7 (Business profits) governs the Source State’s right to tax a foreign enterprise’s ‘business profits. Conversely, if an item of income is not characterized as ‘business profits’, then the other articles in the tax treaty govern the tax treatment. Hence, income characterization is one of the most crucial tax treaty interpretation aspects. Most tax treaties, however, do not include provisions specifically dealing with income characterization.

Generally, the tax treaties include a paragraph in Art. 7 stipulating that if an enterprise’s business income includes an item of income that is specifically dealt with in another treaty article (for example, ‘interest’), then such other article (instead of the business profits article) shall apply.

The above-mentioned requirement conforms to the legal maxim generalia specialibus non derogant, i.e. specific provisions prevail over general provisions. Thus, even though an enterprise may have earned interest income in the ordinary course of business, its treatment under an applicable tax treaty may be governed by the interest article (Art. 11 in most tax treaties) instead of Art. 7 (Business profits), unless the ‘renvoi clause’ in the interest article ‘throws back’ the income to Art. 7 due to effective connection with the permanent establishment. The renvoi clause in the interest article in the most contemporary tax treaties is similar to Art. 11(4) of the OECD Model Convention (see section 2 below).

In some situations, however, the tax treatment of ‘interest income’ may be confined only to the business profits article, so that the interest article may not apply at all. As consequence, if an enterprise’s interest income is not attributable to a permanent establishment in the Source State, then it would not be taxable in the Source State. In other words, such interest income could ‘escape’ the Source State taxation. That has been confirmed by the French Supreme Administrative Court in an interesting case discussed in this article.

This article also analyzes another French decision, wherein the court upheld the characterization of a foreign company’s interest income as ‘business profits’ subject to the tax treatment in accordance with Art. 7(1) of the applicable tax treaty.

We would also look at two interesting Indian decisions. In one case, the interest income of a foreign bank’s Indian branch was characterized as ‘business profits’. In the other case, a foreign company’s income from bank deposits was characterized ‘business profits’. In both the cases, Art. 7 (and not Art. 11) of the applicable tax treaties governed the tax treatment in the Source State.

Finally, we would consider two decisions of the German Federal Tax Court (Bundesfinahzhof). Both the cases involved characterization of partners’ interest incomes for tax treaty purposes. In one case, the Court characterized the interest income as ‘business income’. In the other decision, the Court characterized the income as ‘interest income’.