Exchange of Notes

EXCHANGES OF NOTES

(PROTOCOL 1)

Three notes were exchanged at the time of the signing of the Protocol. A note dealing with exchanges of information is described in the explanation of Article 29 (Exchange of Information). A note dealing with procedures for certifying organizations in the Contracting State as eligible to receive deductible contributions is described in the explanation of Article 15- A (Charitable Contributions). The third note observed that during the negotiations, the Israeli delegation had stressed the need for provisions in the Convention, such as an investment credit, which would promote the flow of United States investment to Israel. While observing that the United States cannot, at the present time, agree to such a provision, the United States offered assurances that, should circumstances change, including the manner in which the United States taxes income from investments in Israel, the U.S. would be prepared to resume discussions with a view to incorporating provisions into the Convention which will minimize the interference of the United States tax system with incentives offered by Israel. These provisions would be consistent with United States tax policies regarding other developing countries.

PROTOCOL 2

UNITED STATES TREASURY DEPARTMENT’S TECHNICAL EXPLANATION OF THE SECOND PROTOCOL AMENDING THE CONVENTION BETWEEN THE GOVERNMENT OF THE UNITED STATES OF AMERICA AND THE GOVERNMENT OF THE STATE OF ISRAEL WITH RESPECT TO TAXES ON INCOME SIGNED ON JANUARY 24, 1993

The Second Protocol (“the Protocol”) signed at Jerusalem on January 26, 1993, amends the Convention Between the Government of the United States of America and the Government of the State of Israel with respect to Taxes on Income, signed on November 20, 1975, as amended by the Protocol signed On May 30, 1980, (“the Convention”). This technical explanation is an official guide to the Protocol. It reflects policies behind particular provisions, as well as understandings reached with respect to the interpretation and application of the Protocol. The technical explanation is not intended to provide a complete comparison between the Protocol and the Articles of the Convention that it amends. The Protocol was accompanied by notes, signed at the time of the signature of the Protocol (the “Exchange of Notes”), indicating the views of the negotiators and the Contracting States with respect to a number of the provisions of the Protocol. In the discussions of each of the Articles of the Protocol in this explanation, the relevant portions of the Exchange of Notes also are discussed.

ARTICLE I

Article I of the Protocol amends Article 1 (Taxes Covered) of the Convention. Paragraph 1 of Article I of the Protocol amends subparagraph (a) of paragraph (1) of Article 1 of the Convention in two respects. In referring to the U.S. Internal Revenue Code (“Code”), it replaces the words “Internal Revenue Code” with the words “Internal Revenue Code of 1986”. This change reflects the fact that the Tax Reform Act of 1986 (“TRA”) was enacted after the date of signature of the Convention. The Convention covers both existing taxes, and taxes substantially similar to those existing taxes that are enacted after the date of signature of the Convention. The TRA introduced certain taxes into the Code that, arguably, arm not substantially similar to those in the pre-1986 Code (e.g., branch profits tax and gross basis tax on shipping profits). In order to make certain that these taxes are covered by the Convention as amended by the Protocol, subparagraph (a) of paragraph (1) is changed to clarify that the base against which any new taxes are judged is the Internal Revenue Code of 1986.

The second change in subparagraph (a) is the addition of the words “but excluding social security taxes” to the description of the U.S. taxes covered. This change, introduced at Israel’s request, conforms the Convention to U.S. policy, which is not to cover social security taxes in t3x treaties, but to reserve coverage of those taxes to social security Totalization agreements.

There is no such agreement in force between the United States and Israel. Because of the exclusion of social security taxes, for example, if an Israeli resident earns personal service income during a temporary visit to the United States, and his remuneration is exempt from U.S. income tax under one of the personal services provisions of the Convention, whether he will be subject to social security taxes will be determined, independent of the Convention, under the rules of U.S. law. The exclusion of social security taxes from the coverage of the Convention does not affect the taxation of social security benefits, which are dealt with in Article 21 (Social Security Payments) of the Convention.

Paragraph 2 of Article I of the Protocol modifies the description of the Israeli taxes covered for purposes of the Convention. The changes conform the coverage under the Convention to current Israeli law. After the Protocol’s amendments, the income taxes covered in the case of Israel are the taxes imposed by the Israeli Income Tax Ordinance, by the Land Appreciation Tax Law, by the Income Tax Law (Adjustments for Inflation), and other taxes on income administered by the Government of Israel. This latter category is defined to include, but is not limited to, the profit tax on barking institutions and insurance companies, and the income tax component of a compulsory loan. Paragraph 1 of the Exchange of Notes clarifies that “other taxes on income administered by the Government of Israel” includes only taxes that are imposed solely under Israeli law.

Paragraph 3 of Article I of the Protocol replaces paragraph (3) of Article 1 of the Convention. This paragraph defines the tax coverage of the Convention for purposes of Article 27 (Nondiscrimination). Under the Protocol, in conformity with standard U.S. treaty policy, the nondiscrimination protection of the Convention will apply to all taxes imposed at all levels of Government — by the Contracting States, or by a state or political subdivision of a state. Paragraph 2 of the Exchange of Notes confirms that the coverage includes taxes imposed by local authorities.

ARTICLE II

Article II of the Protocol amends Article 3 (Fiscal Residence) of the Convention. Paragraph 1 of Article II of the Protocol adds a new subparagraph (c) to paragraph (1) of Article 3, clarifying the circumstances under which a U.S. citizen or “green card” holder is to be treated, for purposes of the Convention, as a U.S. resident. The new subparagraph (c) provides that a U.S. citizen or green card holder, who is not, under the provisions of this Article, a resident of Israel, will be treated as a resident of the United States for purposes of the Convention, and, thereby, entitled to treaty benefits, only if he has a substantial presence, permanent home or habitual abode in the United States. If such a person is a resident both of the United States and of Israel, whether he is to be treated as a resident of the United States or Israel for purposes of the Convention is determined by the tie-breaker rules of paragraph (2) of the Article. If, however, he is resident in the United States and not Israel, but has ties to a third State, in the absence of subparagraph (c), he would always be a resident of the United States, no matter how tenuous his relationship with the United States relative to that with the third State. For example, an individual resident of Mexico who is a U.S. citizen by birth, or who is a Mexican citizen and holds a U.S. green card, but who, in either case, has never lived in the United States, would not, under this rule, be entitled to Israeli benefits under the Convention. On the other hand, a U.S. citizen employed by a U.S. corporation who is transferred to Mexico for two years but who maintains a permanent home or habitual abode in the United States would be entitled to treaty benefits under this rule.

Paragraph 3 of the Exchange of Notes clarifies the meaning of the term “a person resident in Israel”, as the term is used in subparagraph (a)(ii) of paragraph (1) of Article 3 (Fiscal Residence) of the Convention. The term is understood to refer to persons on whom taxes are imposed by Israel pursuant to the Income Tax Ordinance on income from sources outside Israel by virtue of their being Israeli citizens.

Paragraph 2 of Article II of the Protocol amends subparagraph (a) of paragraph (2) of Article 3 of the Convention to correct a cross-reference to a section of the Israeli Income Tax Ordinance that had changed from section 9(16) to section 35 between the time of the signing of the Convention and the negotiation of the Protocol.

Paragraph 3 of Article II of the Protocol amends paragraph (3) of Article 3 of the Convention. The paragraph defines the extent to which dual residents, other than individuals, are to be treated as resident in one of the Contracting States for purposes of the Convention. Under the Convention, the provision applies to dual resident corporations. The Protocol broadens to coverage to all non-individual dual residents. A corporation is resident in the United States if it is created or organized under the laws of the United States or a political subdivision. Under Israeli law a corporation is treated as a resident of Israel if it is either established there or managed and controlled there. Dual corporate residence, therefore, can arise if a U.S. corporation is managed in Israel. Under paragraph (3), the competent authorities are first to seek to settle the question of that person’s residence by mutual agreement, and determine how the Convention is to apply to that person. Unless or until the competent authorities make such a determination, however, the person is not to be treated as a resident of either Contacting State, except for purposes of certain specified Articles. Such persons may claim the benefits of the foreign tax credit under Article 26 (Relief from Double Taxation), and of protection against discrimination under Article 27 (Nondiscrimination). Thus, a dual-resident corporation may claim double taxation relief in one or both of the Contracting States that tax its worldwide income, and neither Contracting State can discriminate against a duel-resident corporation.

Since it is only for the purposes of deriving treaty benefits that such non-individual dual residents are excluded from the Convention, they may be treated as resident for other purposes, such as for determining whether treaty benefits should attach to payments made by such persons. For example, if a dual-resident corporation pays a dividend to a resident of Israel, the U.S. paying agent would withhold on that dividend at the appropriate treaty rate, since reduced withholding is a benefit enjoyed by the resident of Israel, not by the dual resident. The dual- resident corporation which is the payor of the dividend would, for this purpose, be treated as a resident of the United States under the Convention. Paragraph 3, therefore, provides that a non- individual dual resident shall be treated as a resident for purposes of payments of dividends, interest, and royalties by such persons, under paragraph 2 of Article 12 (Dividends), paragraphs (2) and (3) of Article 13 (Interest), and paragraph (l)(b) of a 14 (Royalties). Since information exchange under Article 29 (Exchange of Information and Administrative Assistance) is not limited to residents of the Contracting States, information can be exchanged about dual residents. To the extent that the Convention is relevant for dual-residents it must enter into force for such purposes. Therefore, Article 31 (Entry Into Force) also applies to dual-resident corporations.

Paragraph 4 of the Exchange of Notes applies to paragraph (3) of Article 3. It clarifies the fact that when one of the provisions of the Convention applies to a dual resident, any other provision necessary to give effect to that provision will also apply. For example, as noted above, a dividend paid by a dual-resident corporation to a resident of one of the Contracting States is entitled to the benefit of the reduced rate of tax at source. The source rule in paragraph (1) of Article 4 (Source of Income) will apply to determine the source of a dividend for this purpose, even though Article 4 is not specified in paragraph (3) of Article 3 (Fiscal Residence).

ARTICLE III

Article III of the Protocol amends two of the source rules in Article 4 (Source of Income) of the Convention. Both changes are technical changes necessary to conform the source rules to the substantive taxing rules of the Convention as they are amended by the Protocol. Paragraph 1 of Article III amends the source rule for gain from the sale or exchange of personal property to make the source rule for gain on the disposition of corporate shares reciprocal. This change conforms the source rule to the rule in Article 15 (Capital Gains) for the taxation of gain on the disposition of corporate shares, which is amended by Article X of the Protocol to make it apply reciprocally. As provided in paragraph 3 of Article XIII of the Protocol, this source rule applies notwithstanding the saving clause of paragraph (3) of Article 6 (General Rules of Taxation).

Paragraph 5 of the Exchange of Notes relates to paragraph 1 of Article III of the Protocol. It notes that, in applying the rules of the Convention to gain received by a U.S. resident on the disposition of shares in an Israeli corporation, section 865(h) of the Code say be applied to limit the foreign tax credit allowed to the U.S. resident on a per-item of income basis.

Paragraph 2 of Article III of the Protocol amends paragraph (7) of Article 4 of the Convention to conform the language of the source rule for Government remuneration, dealt with in Articles 21 (Social Security Payments) and 22 (Governmental Functions), to the broadened definition of the term “public funds of one of the Contracting States” in Article 22, resulting from Article XI of the Protocol.

ARTICLE XV

Article IV of the Protocol amends paragraph (5) of Article 5 (Permanent Establishment) of the Convention to conform the rule of the paragraph to that reflected in the current U.S., U.N. and OECD Model Conventions. As amended by the Protocol, paragraph (5) provides that a dependent agent of a resident of a Contracting State will constitute a permanent establishment in the other Contracting State if the agent has, and habitually exercises in the other State, the authority to conclude contracts in the name of the resident, unless his activities are of the type that would not give rise to a permanent establishment under the provisions of paragraph (3) of Article 5.

ARTICLE V

Article V of the Protocol amends Article 6 (General Rules of Taxation) of the Convention in several respects. Paragraph 1 of Article V of the Protocol conforms the rule of paragraph (3) of Article 6 to current U.S. treaty policy regarding the treatment of former U.S. citizens. It provides that, for purposes of the saving clause in paragraph (3), a citizen of a Contracting State includes a former citizen whose loss of citizenship had as one of its principal purposes the avoidance of tax. Such a former citizen is to be treated as a citizen for this purpose only for £ period of 10 years following the loss of citizenship. In the United States, such a former citizen is taxable in accordance with the provisions of section 877 of the Code for 10 years following the loss of citizenship. The paragraph also provides for consultation by the competent authorities on the purposes of an individual’s loss of citizenship.

Paragraph 2 of Article V of the Protocol amends subparagraph (a) of paragraph (4) of Article 6 of the Convention, which contains exceptions to the saving clause. The source State’s exemptions of alimony and annuities, and the residence State exemption for child-support payments, in paragraph (2) and (3), respectively, of Article 20 (Private Pensions and Annuities), are added to the general exceptions to the saving clause.

Paragraph 3 of Article V of the Protocol amends paragraph (6) of Article 6 (General Rules of Taxation) of the Convention. Paragraph (6) contains a so-called “remittance basis” rule, under which source-country relief under the Convention applies only to that portion of an item of income that is remitted to the residence country, if the rule in the residence country is to subject to tax only the remitted income. Under the Convention the income must be remitted during the year in which the income accrues. The protocol modifies this rule to allow source relief if the income is remitted during the year of accrual or during the first three months of the following year. This amendment permits relief from source-country tax even in cases where there is a short time leg between the time of accrual of the income and the time it is remitted that may extend into the next taxation year.

Paragraph 4 of Article V of the Protocol adds two new paragraphs to Article 6 (General Rules of Taxation) of the Convention. The new paragraphs are designated as paragraphs (7) and (8), and the existing paragraph (7) becomes paragraph (9).

The new paragraph (7) elaborates on paragraph (8) of Article 4 (Source of Income), paragraphs (1) and (2) of Article 8 (Business Profits), paragraph (5) of Article 12 (Dividends), paragraph (5) of Article 13 (Interest), paragraph (3) of Article 14 (Royalties), and subparagraph (c) of paragraph (1) of Article 15 (Capital Gains). This paragraph incorporates the principle of Code section 864(c)(6) into the Convention. Like the Code section on which it is based, the new paragraph (7) provides that any income or gain attributable to a permanent establishment (or, in the context of Articles 12, 13 and 14, a fixed base as well) during its existence is taxable in the Contracting State where the permanent establishment (or fixed base) is situated even if the payments are deferred until after the permanent establishment (or fixed base) no longer exists.

The new paragraph (8) is intended to deal with changes in law or in treaty policy of either of the Contracting States, that have the effect of changing the application of the Convention in a significant manner or that alter the relationship between the Contracting States. Paragraphs 6 and 7 of the Exchange of Notes elaborate the procedure established in paragraph (8) of the Article. Paragraph (8) provides, first, that, in response to a change in the law or policy of either State, the appropriate authority of either State may request consultations with its counterpart in the other State to determine whether a change in the Convention is appropriate. The “appropriate authorities” may be the Contracting States themselves, communicating through diplomatic channels, or they may be the competent authorities under the Convention, communicating directly. The request for consultations may come either from the authority of the Contracting State making the change in law or policy, or it may come from the authority of the other State. If the authorities determine, on the basis of the consultations, that a change in domestic legislation has significantly altered the balance of benefits provided by the Convention, they will endeavor, promptly, to amend the Convention to restore an appropriate balance. The authorities also may consult regarding a change in treaty policy or domestic law by one of the Contracting States. The purpose of these consultations would be to determine whether the change in policy should result in amendment of the Convention.

Paragraph 7 of the Exchange of Notes provides several examples of the kinds of unilateral changes that may prompt a decision to seek to negotiate amendments to the Convention. Such a decision may result from the granting by one of the Contracting States of favorable benefits to a third country, such as an agreement to Liberalize the foreign tax credit granted by treaty. Another example provided in the Exchange of Notes is the granting to a third- country partner of corporate/shareholder integration benefits. Paragraph 7 of the Exchange of Notes also suggests that, as long as the U.S.-Israel Free Trade Agreement remains in force, if one Contracting State treats expenses, for example research and development expenses, incurred within that State more favorably than the same expenses incurred within the other State, such a change would lead to consultations regarding possible amendments to the Convention.

Paragraph 6 of the Exchange of Notes states the agreement of the Contracting States that if the United States grants tax sparing credits under agreement with any other country, the Convention will be amended promptly to incorporate such a provision.

ARTICLE VI

Article VI of the Protocol amends Article 7 (Income from Real Property) by replacing the text of paragraph (3) with a new text. The paragraph deals with the taxation of gain attributable to the alienation of real property. Gain from the alienation of the real property itself is dealt with in paragraph (1) of Article 7. Under paragraph (3), the Contracting State in which the underlying real property is located may tax the gain. The purpose of the change in paragraph (3) is to cover the full range of gains attributable to real property that may be taxed by the United States under the FIRPTA provisions in section 897 of the Code.

Subparagraph (a) of paragraph (3) of Article 7 provides that the United States may tax a resident of Israel on gain from the alienation of a U.S. real property interest, or from the alienation of an interest in a partnership, trust or estate, to the extent attributable to a United States real property interest. The term “U.S. real property interest” is understood to have the same meaning as the term has in section 897 of the Code. Thus, an Israeli resident would be subject to U.S. tax on gain from the alienation of shares in a U.S. corporation, the property of which consists principally of U.S.-situs real property. Similarly, an Israeli resident would be subject to tax on a liquidating distribution by such a U.S. corporation and on a distribution by a Real Estate Investment Trust (“REIT”) attributable to gain from the alienation of U.S. -situs real property. This provision also preserves the U.S. right to tax gain from the alienation of an int5re5t in a partnership, trust or estate, to the extent that the gain is attributable to U.S.-situs real property. Subparagraph (b) makes the provision reciprocal, and provides that Israel may tax a U.S. resident on gain from the alienation of comparable interests in Israeli real property.

ARTICLE VII

Article VII of the Protocol amends Article 12 (Dividends) of the Convention. Paragraph 1 of Article VII of the Protocol makes a technical, clarifying amendment to subparagraph (b) of paragraph (2) of Article 12. Subparagraph (b) provides for reduced rates of tax at source for intercorporate dividends under certain circumstances. The amendment clarifies that the rules in the subparagraph apply to dividends paid both by U.S. and Israeli corporations.

Paragraph 2 of Article VII of the Protocol introduces a new paragraph (3) to Article 12 of the Convention, and renumbers the previous paragraphs (3) and (4) of the Convention as paragraphs (4) and (5) respectively. The new paragraph (3) deals with dividends paid by U.S. entities that are Regulated Investment Companies (“RICs”) and REITs (subparagraph (a)), and by equivalent conduit organizations in Israel (subparagraph (b)). Dividends paid by RICs are denied the 12.5 percent direct dividend rate and subjected to the 25 percent portfolio dividend rate regardless of the percentage of voting shares held directly by a corporate recipient of the dividend. A dividend paid by a RElT will be taxed in the United States at full statutory rates (30 percent), unless the beneficial owner of the dividend is an individual resident of Israel who owns less that a 10 percent interest in the RElT, in which case he will be taxed at the portfolio dividend withholding rate of 25 percent.

The denial of the 12.5 percent withholding rate at source to all RIC and RElT shareholders, and the denial of the 25 percent rate to most shareholders of REITs is intended to prevent the use of these conduit entities to gain unjustifiable benefits for certain shareholders. For example, an Israeli corporation that wishes to hold a diversified portfolio of U.S. corporate shares may hold the portfolio directly and pay a U.S. withholding tax of 25 percent on all of the dividends that it receives. Alternatively, it may place the portfolio of U.S. stocks in a RIC, in which the Israeli corporation owns most of the shares, but in which the corporation has arranged to have a sufficient number of small shareholders to satisfy the RIC diversified ownership requirements. Since a RIC generally pays no corporate-level U.S. income tax there is no U.S. tax cost to the Israeli corporation of interposing the RIC as an intermediary in the chain of ownership. That interposition has, however, absent the special rule in paragraph (3), served to transform portfolio dividends, taxable in the United States under the Convention at 25 percent into direct investment dividends, taxable at only 12.5 percent.

Similarly, a resident of Israel may hold U.S. real property directly, and pay U.S. tax either at a 30 percent rate on the gross income or, generally, at a 31 or 35 percent on the net income. As in the preceding example, by placing the real estate holding in a REIT, the Israeli investor can transform real estate income into dividend income, and in the process, absent the special rule, transform, at no tax cost, high-taxed income into lower-taxed income. In the absence of the special rule, if the RElT shareholder is an Israeli corporation that owns at least a 10 percent interest in the REIT, the withholding rate would be 12.5 percent; in all other cases it would be 25 percent. In either event, with one exception, a tax of at least 30 percent would be significantly reduced. The exception is the relatively small individual Israeli investor who might be subject to a U.S. tax of 15 percent of the net income even if he earned the real estate income directly. Under the rule in subparagraph (a), such individuals, defined as those holding less than a 10-percent interest in the REIT, remain taxable at source at a 25-percent portfolio dividends withholding rate.

Subparagraph (b) of paragraph (3) provides analogous rules for dividends paid by certain Israeli corporations. Under that new subparagraph, the reduced rates of tax at source on dividends provided in paragraph (2) do not apply to dividends paid by certain Israeli corporations that are taxed in a ·pass-through” manner. The income of these corporations is taxed in the manner described in Sections 64 and 64A of the Israeli Income Tax Ordinance. Paragraph 9 of the Exchange of Notes explains that there are several types of “pass-through”corporations that meet the standard of subparagraph (b). The corporation may be exempt from tax; the shareholders may be subject to tax on their pro-rata shares of the corporation’s income; or the corporation say deduct its dividends paid from its taxable income. In cases covered by this subparagraph, the income is treated as if it were business profits from a permanent establishment, taxable according to the rules of Article 8 (Business Profits).

ARTICLE VIII

Article VIII of the Protocol amends Article 13 (Interest) of the Convention. Paragraph 1 of Article VIII adds a new subparagraph (b) to paragraph (2) of Article 13, designating paragraph (2), as it appeared in the Convention, as subparagraph (a) of paragraph (2). Subparagraph (b) provides an alternative rule for the taxation of interest at source. Subparagraph (a) provides for withholding at source at either a 17.5 or 10 percent rate, the latter applying to interest on loans made by financial institutions. The gross-basis withholding tax of subparagraph (a) will not apply if, under subparagraph (b), the interest recipient elects to be taxed by the source State on its net interest income, under-the rules of Article S (Business Profits), as though the interest income were industrial and commercial profits, attributable to a permanent establishment in the source State. The paragraph further provides for the adoption by each competent authority of rules far determining and reporting taxable income under this provision. Each competent authority also may adopt procedures requiring the provision by the taxpayer of adequate books and records for determining the proper amount of net income. The U.S. competent authority will provide rules for the apportionment of expenses, as would be required under Article 8, in determining net income for purposes of U.S. source basis tax.

Paragraph 2 of Article VIII of the Protocol adds a new paragraph (8) to Article 13 (Interest). Paragraph (8) provides that the reductions in tax at source for interest provided for in paragraph (2), and the exemption at source provided for in paragraph (3), do not apply to an excess inclusion with respect to a residual interest in a U.S. real estate mortgage investment conduit (REMIC). This class of income, therefore, will remain subject to the statutory 30-percent U.S. rate of tax at source under paragraph 1. This provision is consistent with the policy of 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 when these interests are initially offered for sale. 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 10 of the Exchange of Notes relates to paragraph (8) of Article 13 (Interest). It reflects the understanding that paragraph (8) was added at the request of the United States to address a problem of domestic tax avoidance arising under U.S. internal law, and notes that the United States intends to include similar provisions in all of its future treaties. The Exchange of Notes also acknowledges that the United States possibly could revise its internal laws in the future to address this problem in a manner other than by imposing tax on the recipient of the excess inclusion so that an excess inclusion under the revised laws would be treated as ordinary interest income in the hands of nonresident recipients and would be eligible for the exemptions from tax applicable to interest income under the lads of the United States. In that case such exemption would, notwithstanding paragraph (8), apply to an Israeli recipient of an excess inclusion. It is further noted that if the United States fails to include a provision similar to paragraph (8) of Article 13 in any tax treaty signed subsequent to the entry into force of this Convention, without having revised its internal laws in the manner suggested in the preceding sentence, such a change in U.S. treaty policy would make it appropriate to amend the Convention on this matter, pursuant to paragraph (8) of Article 6 of the Convention.

ARTICLE IX

Article IX of the Protocol adds a new Article 14A (Branch Tax) to the Convention. Article 14A provides for the imposition by the United States of a branch tax, both on the “dividend equivalent amount” and on “excess interest”, and the imposition by Israel of a comparable tax should Israeli law be amended in the future to impose such a tax. Paragraph (1) of Article 14 confirms the right of each of the Contracting States to impose on a resident of the other, a tax in addition to the tax allowable under the other provisions of the Convention.

The bases of the U.S. taxes are described in subparagraph (a) of paragraph 2. The “dividend equivalent amount” is described in sub-subparagraph (i) and the excess interest that is subject to U.S. tax is described in sub-subparagraph (ii). The Convention does not define the term “dividend equivalent amount”. It is, therefore, understood to have the same meaning as in section 884(b) of the Code and the regulations thereunder. Generally the dividend equivalent amount is the earnings and profits of the foreign corporation (i.e., the profits of the corporation after certain adjustments including a reduction for U.S. corporate income tax) that are effectively connected with the conduct of its trade or business in the United States, decreased by any increase during the taxable year in the corporation’s U.S. assets less liabilities (“U.S. net equity”) or increased by any decrease in its U.S. net equity. Under the Convention the dividend equivalent amount 15 subject to U.S. tax only to the extent it is attributable to a U.S. permanent establishment.

Under the Convention, the dividend equivalent amount for any year approximates the dividend that a U.S. branch office would have paid its home office during the year if the branch had been operated as a separate U.S. subsidiary company. The dividend equivalent amount is determined taking into account not only effectively connected earnings and profits (or profits that are deemed to be effectively connected) that are attributable to a permanent establishment in the United States but also most profits from the disposition or operation of real estate that are subject to net basis income taxation in the United States under Article 7 (Income From Real Property)) or Article 15 (Capital Gains). Thus, the United States may impose its branch profits tax on the earnings and profits of an Israeli corporation attributable to a permanent establishment in the United States and on the earnings and profits that, in accordance with the Convention, are subject to taxation under U.S. internal law on a net basis either because the Israeli corporation has elected under Code section 882(d) to treat income from real property not otherwise taxed on a net basis as effectively connected income or because the income is gain that is taxable on a net basis, e.g., because it is attributable to the disposition of a United States Real Property Interest (other than an interest in a United States Real Property Holding Corporation).

Subparagraph (ii) of subparagraph (a) provides for the imposition of the U.S. tax on excess interest. Under section 884(f)(l)(B) of the Code, excess interest is the excess of the total amount allowable as a deduction in computing the U.S. effectively connected income of a foreign corporation over the total interest paid by the foreign corporation’s U.S. trade or business. Under the Convention, the tax on excess interest applies only to the excess of interest that is deductible in computing

(i) the U.S. tax on income attributable to a permanent establishment of an Israeli corporation in the United States and

(ii) the U.S. tax on income or gain from real property (although not including, under current U.S. law, gain on shares in a United States Real Property Holding Corporation) over the interest paid by the foreign corporation’s U.S. permanent establishment.

Israel does not impose a comparable tax on a dividend equivalent amount or on excess interest under current law. Subparagraph (b) of paragraph (2), however, permits Israel to impose a tax comparable to the U.S. tax described in paragraph (a) should Israeli law, in the future, be amended to provide such a tax. The permitted Israeli tax could be imposed on an Israeli branch of a U.S. Corporation such that the branch would be taxed in a manner comparable to a similarly situated Israeli subsidiary and its U.S. parent corporation. The language of the Article permits the tax to be imposed on an Israeli branch, rather than a permanent establishment, because Israel was reluctant to limit its future flexibility in designing a tax. However, as explained in paragraph 11 of the Exchange of Notes, Israel has agreed that, if Israel should, at some time in the future, impose a tax under subparagraph (b) of this Article in circumstances where the United States would not impose a tax under subparagraph (a), the competent authorities will consult with a view to conforming the two countries’ rules under the Convention. Paragraph 11 of the Exchange of Notes states a further understanding that if a resident of a Contracting State qualifies for benefits under the Convention (i.e., the resident satisfies one or more of the tests of Article 25 (Limitation on Benefits)) that person will not be subject to the branch tax imposed by the other Contracting State, except as provided in the Convention. This merely confirms to Israel the result under U.S. law that the “qualified residence” rules of Code section 884(e)(4) do not override the Limitation on Benefits rules of the Convention to deny branch tax benefits to a resident of Israel in circumstances where Convention’s benefits would have been allowed under Article 25.

Paragraph (3) specifies the rates at which the taxes described in paragraph (2) may be imposed. Under subparagraph (a), the rate applicable in the United States to the tax on dividend equivalent amount may not exceed 12.5 percent. This is the general rate provided for in paragraph (2) of Article 12 (Dividends) applicable to direct investment dividends. Under subparagraph (b), the maximum rate of U.S. tax on excess interest is 5 percent. The rate should approximate the rate at which interest derived by a resident of Israel from U.S. sources is taxed by the United States. The 5 percent rate in subparagraph (b) represents a “blended rate”, reflecting the fact that under Article 13 (Interest) subject to source country tax at a variety of rates varying from zero to 17.5 percent on gross interest, or at regular graduated rates on interest less expenses. Subparagraph (c) provides that, in the event that Israel imposes a tax of the type dealt with in Article 14A, the rate will not exceed the rate applicable in the United States under subparagraphs (a) and (b) on analogous classes of income.

ARTICLE X

Article X of the Protocol makes two amendments to Article 15 (Capital Gains) of the Convention, which provides that gain derived by a resident of a Contracting State from the sale, exchange or other disposition of a capital asset shall be exempt from tax in the other Contracting State, except in certain enumerated cases.

Paragraph 1 of Article X of the Protocol amends subparagraph (a) of paragraph (1) of Article 15 of the Convention which cross refers to Article 7 (Income from Real Property) in order to better describe the rights of the situs state to tax gain attributable to real property under that Article. The amendment is necessary in light of the clarifying changes to Article 7 made by Article VI of the protocol.

Paragraph 2 of Article X of the protocol amends subparagraph (e) of paragraph (1) of Article 15 of the Convention in order to modify the cases in which Israel may tax gain derived by a U.S. resident from the sale, exchange or other disposition of shares in an Israeli corporation. Although the subparagraph is worded reciprocally, it does not provide any additional taxing rights to the United States. Under the Code the only gain (other than gain that is effectively connected with a U.S. trade or business) from the disposition of shares in a U.S. corporation by a nonresident alien or foreign corporation that the United States taxes is gain from the disposition of shares in a United States Real property Holding Corporation, and that taxing right is granted by Article 7 of the Convention.

Under subparagraph (e) of paragraph (1) of Article 15 of the Convention as amended by the protocol, Israel may tax a U.S. resident on gain from the disposition of shares in an Israeli corporation provided the U.S. resident owned, either directly or indirectly, at any time during the 12-month period prior to the sale, shares possessing at least 10 percent of the voting power of the corporation. This gain is treated as foreign source income for purposes of determining the limitation on the U.S. foreign tax credit under Article 4 (Source of Income) as amended by Article II of the Protocol and Article 26 (Relief From Double taxation) as amended by Article XIII of the protocol. Prior to amendment by the protocol, the required ownership threshold was higher (more than 50 percent of the corporation’s voting power during the 12-month period prior to the sale) and there also was a requirement that a substantial portion of the corporation’s assets was used to carry on business in Israel for the three taxable years prior to the disposition.

Paragraph 3 of Article X of the protocol adds a new paragraph (2) to Article 15 which limits the gain that Israel may tax under subparagraph (e) of paragraph (1) to the amount of boot received in an otherwise tax-free reorganization of a U.S. affiliated group. In order for the provision to apply three conditions must be satisfied. First, the transferor and the transferee must be resident in the same Contracting State (the United States). Second, the transferor and the transferee must own directly or indirectly 80 percent or more of the voting rights and value of the other, or a company resident in the same Contracting State as the transferor and the transferee must own directly, or indirectly through companies resident in the same Contracting State, 80 percent or more of the vote and value of the transferor and transferee. (This condition would be satisfied by a U.S. affiliated group.) Finally, the transferee’s basis, for purposes of determining gain or loss in the State in which it is resident, must be determined, in whole or in part, by reference to the transferor’s basis (i.e., the transaction must be a tax-free reorganization under Section 368 of the Code so that the transferee’s basis is determined under section 362(b) of the Code.

If these three conditions are satisfied then the gain that Israel may tax under subparagraph (e) is limited to the amount of cash or other property received by the transferor, which is the Same as the amount of gain that would be recognized under section 356(a) of the Code and taxed by the United States. In the event a larger amount of gain may be taxed in the transferor’s State of residence, then the other Contracting State may tax the gain in accordance with its domestic law (applied consistently with the Convention). However, if the carryover-basis rule of section 362(b) of the Code applies to a transaction then the Limitation of section 356(a) of the Code must also apply, so that this is not a possibility under U.S. law at this time.

ARTICLE XI

Article XI of the Protocol amends Article 22 (Governmental Functions) of the Convention. The Protocol adds two new paragraphs to the Article that expand the scope of “public funds of a Contracting State” and “employment by a Contracting State” to cover more than the Contracting States themselves. Paragraphs (2) and (3) expand these terms to mean public funds of, and employment by,

(i) a Contracting State or a political subdivision or local authority thereof;

(ii) a corporation that is wholly owned by a Contracting State or a political subdivision or local authority thereof, provided the corporation performs functions of a governmental nature; and

(iii) a body that is treated for tax purposes the same as a Contracting State or a political subdivision or local authority thereof and that performs functions of a Governmental nature.

ARTICLE XII

Article XII of the Protocol replaces Article 25 (Investment or Holding Companies) of the Convention with a new Article 25 (Limitation on Benefits). Article 25 ensures that source-basis tax benefits granted by a Contracting State pursuant to the Convention are limited to the intended beneficiaries — residents of the other Contracting State that have a substantial nexus with that State. For example, a resident of a third State might establish an entity resident in a Contracting State for the purpose of deriving income from the other Contracting State and claiming source- State benefits with respect to that income. Absent Article 25, the entity would generally be entitled to benefits as a resident of a Contracting State, subject, to any limitations imposed by the domestic law of the source State, (e.g., business purpose, substance-over-form, step transaction or conduit principles)

Paragraph 1 describes two conditions either of which if satisfied will disqualify a person from claiming benefits under the Convention, unless the person qualifies for benefits under either paragraphs (3) or (4). Paragraph (2) contains a special rule aimed at companies that issue “alphabet” stock to third country residents in order to allow them to effectively claim benefits under the Convention. Although the structure of this Article differs from the limitation on benefits articles of other recent treaties (e.g., the Convention Between the Federal Republic of Germany and the United States of America) it achieves the same result.

Under paragraph (l), benefits will be denied to a resident of a Contracting State, such as a corporation, partnership or trust, if either

(i) 50 percent or more of the beneficial interests in the person (or, in the case of a corporation, 50 percent or more of the voting power or value or its shares) is owned, directly or indirectly, by individuals who are not residents of a Contracting State, and who are not citizens of a Contracting State who are subject to tax in that State on worldwide income, or

(ii) 50 percent or more of the person’s gross income is used in substantial part, directly or indirectly, to meet liabilities in the form of deductible payments (including liabilities for interest or royalties) to persons who are residents of a state other than a Contracting State, and who are not citizens of a Contracting State who are subject to tax in that State on worldwide income.

The rationale for disqualifying a resident of a Contracting State in these two cases is that treaty benefits can be indirectly enjoyed not only by equity holders of an entity, but also by that entity’s various classes of obligees, such as lenders, licensors, service providers, insurers and reinsurers, and others. Accordingly, it is not enough, in order to prevent such benefits from inuring substantially to third-country residents, merely to require substantial ownership of the entity by treaty country residents. It also is necessary to require that the entity’s deductible payments be made in substantial part to such treaty country residents or their equivalents.

Paragraph (2) address the potential for abuse when a company (or another company that controls that company) issues a class of shares that entitles its holders to a disproportionately high share of income derived in the other Contracting State, either from activities performed or assets located in that State. If 50 percent or more of the shares of this class is owned, directly or indirectly, by persons that would disqualify the corporation for benefits under subparagraph (a) of paragraph (1), then the Convention’s benefits with respect income attributable to those assets or activities will be denied by paragraph (2). For example, a U.S. holding company could issue a class of shares (class B shares) entitling the class B shareholders to the dividends received from an Israeli subsidiary operating in Israel. If more than 50 percent of the vote and value of all of the U.S. company’s shares is held by U.S. residents the holding company would not be denied benefits under paragraph (1). However, if a majority of the class B shares were held by third- country residents, paragraph (2) would deny the benefits of the Convention (reduced Israeli tax at source) with respect to the Israeli subsidiary’s dividends. Were this not the rule and assuming there were a treaty in effect between the United States and the third country to reduce the U.S. dividend withholding tax, this structure would provide opportunities for third country residents to effectively claim the benefits of the Convention on dividends paid by the Israeli corporation.

Paragraph (3) identifies a number of classes of persons resident in one Contracting State that are entitled to treaty benefits from the other, either in full or with respect to particular items of income, notwithstanding paragraphs (1) and (2). First, under subparagraph (a), individuals who are residents of a Contracting State are, without qualification, entitled to benefits under the Convention. Second, subparagraph (b) provides that

(i) a Contracting State or a political subdivision or local authority thereof,

(ii) a corporation that is wholly owned by a Contracting. State or a political subdivision or local authority thereof, provided the corporation performs functions of a Governmental nature, and

(iii) a body that is treated for tax purposes the same as a Contracting State or a political subdivision or local authority thereof and that performs functions of a Governmental nature, are entitled to benefits under the Convention.

Subparagraph (c) of paragraph (3) provides a test for eligibility for benefits that looks not solely at objective characteristics of the person deriving the income, but at the nature of the activity carried on by that person and the connection between the income and that activity. Under subparagraph (c) a resident of a Contracting State deriving income from the other Contracting State is entitled to benefits if the recipient is engaged in an active trade or business in its State of residence, and the item of income in question is derived in connection with, or is incidental to, that trade or business. For this purpose an active trade or business does not include the business of making or managing investments, unless these activities are banking or insurance activities carried on by a bank or insurance company. This relationship test is applied separately for each item of income, and it is intended that the provisions of this paragraph are self-executing. The tax authorities say, of course, on review, determine that the taxpayer ham improperly interpreted the subparagraph and is not entitled to the benefits claimed.

The first six examples in the Memorandum of Understanding Regarding the Scope of the Limitations on Benefits Article in the Convention Between the Federal Republic of Germany and the United States of America illustrate the Situations intended to be covered by this provision. For example, income is considered “derived in connection with” an active trade or business when the income is a dividend paid to a United States manufacturing company by its sales subsidiary in Israel that is selling in Israel the output of the U.S. parent. Income would be considered “incidental to” an active trade or business if, for example, the income were dividends earned by an Israeli corporation from investing some of its working capital, temporarily, in U.S. preferred shares. Even if the Israeli company has no other activities in the United States, the dividends from those shares would be considered incidental to the active business of the company in Israel, and would be entitled to U.S. treaty benefits.

Under subparagraph (d) of paragraph (3), a corporation that is a resident of a Contracting State is entitled to treaty benefits from the other Contracting State if there is substantial and regular trading in the corporation’s principal class of shares on a recognized stock exchange. The term “recognized stock exchange” is defined in paragraph (5) of the Article to mean, in the United States, the NASDAQ System and any stock exchange that is registered as a national securities exchange with the Securities and Exchange Commission for purposes of the Securities Exchange Act of 1934. In Israel, the term means the Tel Aviv Stock Exchange, and any other Israeli stock exchange that say be approved by the Israeli Minister of Finance. The competent authorities may, by mutual agreement, recognize additional exchanges for purposes of subparagraph (d).

Subparagraph (e) of paragraph (3) provides that a not-for-profit organization that is a resident of a Contracting State is entitled to benefits from the other Contracting State if it satisfies two conditions:

(i) it generally must be exempt from tax in its State of residence by virtue of its not-for-profit status; and

(ii) more than half of the beneficiaries, members or participants, if any, in the organization must be persons entitled, under this Article, to the benefits of the Convention.

The not-for-profit organizations dealt with in the subparagraph include pension funds, pension trusts, private foundations, trade unions, trade associations and similar organizations. Thus, an Israeli pension fund that provides pension benefits principally to Israeli residents would be entitled to benefits with respect to its U.S. source investment income.

Paragraph (4) provides that a resident of a Contracting State that derives income from the other Contracting State and is not entitled to the benefits of the Convention under other provisions of the Article may, nevertheless, be granted benefits at the discretion of the competent authority of the Contracting State in which the income arises. The paragraph further provides that if a competent authority proposes to deny a request for benefits under this provision, either competent authority may request consultations with the other to discuss the issue.

The paragraph itself provides no guidance to competent authorities or taxpayers as to how the discretionary authority is to be exercised. It is understood, however, that in making determinations under paragraph (4), the competent authorities will take into account all relevant facts and circumstances. The factual criteria that the competent authorities are expected to take into account include the existence of a clear business purpose for the structure and location of the income earning entity in question; the conduct of an active trade or business (as opposed to a mere investment activity) by such entity; and a valid business nexus between that entity and the activity giving rise to the income. Paragraph 13 of the Exchange of Notes, for example, states the understanding that benefits would be likely to be granted by the competent authority in the case of a resident of a Contracting State that did not pass the base-erosion test of paragraph (1) of the Article because of large interest payments on a bona-fide loan from a financial institution resident in a third country. For this purpose a “bona-fide loan” would not include a conduit financing arrangement recharacterized under section 7701(1) of the Code or Rev. Rul. 87-89, 1987-2 C.B. 195.

For purposes of implementing paragraph (4), a taxpayer will be permitted to present his case to his competent authority for an advance determination based on the facts, and will not be required to wait until the tax authorities of one of the Contracting States have determined that benefits are denied under one of the other provisions of the Article. It also is 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.

Subparagraph (c) of paragraph (4) provides that the competent authorities are expected to consult with a view to developing agreed procedures for the application of Article 25, including, as provided in paragraph 14 of the Exchange of Notes, the development of a Memorandum of Understanding to provide guidance to both taxpayers and tax administrations. It is further expected that as, over time, the tax authorities of the Contracting States gain experience in administering the provisions of Article 25, further guidance will be developed and published.

ARTICLE XIII

Article XIII of the Protocol amends Article 26 (Relief from Double Taxation) of the Convention. Paragraph (1) of Article XIII replaces paragraph (2) of Article 26. Due to changes in law, paragraph (2) of the Convention dealing with payments made or received on a compulsory loan to Israel is no longer relevant. The new paragraph (2) provides special rules for the tax treatment in both Contracting States of certain types of income derived from U.S. sources by U.S. citizens who are resident in Israel. Since U.S. citizens are subject to United States tax at graduated rates on their worldwide income, the U.S. tax on the U.S. source income of a U.S. citizen resident in Israel will often exceed the U.S. tax allowable under the Convention on an item of U.S. source income derived by a resident of Israel who is not a U.S. citizen. Without this provision U.S. citizens resident in Israel would potentially be subject to double taxation with respect to this income.

Subparagraph (a) of paragraph (2) provides a special Israeli credit rule with respect to items of income that are either exempt from U.S. tax or subject to reduced rates of U.S. tax under the provisions of the Convention when received by Israeli residents who are not U.S. citizens. The Israeli foreign tax credit allowed by subparagraph (a) under these circumstances, to the extent consistent with Israeli law, need not exceed the U.S. tax that may be imposed under the provisions of 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 (3) of Article E (General Rules of Taxation). Thus, if a U.S. citizen resident in Israel receives U.S. source dividends, the Israeli foreign tax credit would be limited to 25 percent of the dividend– the U.S. tax that may be imposed under subparagraph (a) paragraph (2) of Article 12 (Dividends) — even if the shareholder is subject to a U.S. rate of tax of 31 percent (or more) because of his U.S. citizenship.

Subparagraph (b) of paragraph (2) deals with the potential for double taxation that can arise as a result of the absence of a full Israeli foreign tax credit for the U.S. tax imposed on its citizens resident in Israel. The subparagraph provides that the United States will credit the Israeli income tax paid, after the Israeli credit provided for in subparagraph (a). It further provides that in allowing the credit, the United States will not reduce its tax below the amount that is allowed as a creditable tax in Israel under subparagraph (a) (i.e., the amount that the United States may impose on an Israeli resident under the convention). Since the income that is dealt with in this paragraph is U.S. source income, special rules are required to resource some of the income as Israeli source in order for the United States to be able to credit the Israeli tax. This resourcing rule is provided for in subparagraph (c), which deems the items of income referred to in subparagraph (a) of paragraph (2) to be from Israeli sources to the extent, but only to the extent, necessary to avoid double taxation under subparagraph (b). Thus, no excess credits can be generated in applying this rule that can be used against U.S. tax on any other item of income.

Paragraph 2 of Article XIII of the Protocol makes a clarifying amendment to the Israeli foreign tax credit rule in paragraph (3) of Article 26. As amended, the paragraph makes clear that the Israeli foreign tax credit is applied in a manner consistent with the provisions end limitations of Israeli law concerning the provision of a foreign tax credit, as the law is in force at the time the provision is being applied. However, the law as it is applied at any time must be consistent with the general provisions of the paragraph, i.e., it must continue to provide for a full foreign tax credit for U.S. income tax.

Paragraph 3 of Article XIII of the Protocol adds a new paragraph (4) to Article 26 of the Convention. Paragraph (4) specifies how the source rules in Article 4 (Source of Income) are to apply for purposes of computing the foreign tax credit under Article 26. It provides, first, that the source rule for the taxation of gain on tangible or intangible assets in paragraph (6) of Article 4 (Source of Income) applies for the purpose of computing the foreign tax credit under Article 26. It is intended that this rule apply notwithstanding the saving clause of paragraph (3) of Article 6. Thus, where subparagraph (a) of paragraph (1) of Article 15 (Capital Gains) gives one Contracting State the right to tax the gain of a resident of the other on the alienation of shares in a corporation of the first-mentioned State, the gain will be sourced, for credit purposes, in that first-mentioned State. Paragraph (4) provides further that the other source rules in Article 4 also will apply for foreign tax credit purposes, to the extent not prohibited by the domestic law of the contracting State that is providing the credit. Thus, in computing the U.S. foreign tax credit section 904(g) of the Code, which provides for particular source rules for foreign tax credit purposes, will apply. Moreover, other source rules in Article 4 also would yield to conflicting source rules of domestic law without regard to their date of enactment.

Article XVII of the Protocol, providing the rules for entry into force and effective dates for the Second Protocol, contains a rule that refers to Article 26. Article XVII of the Protocol provides that when the Second Protocol (and, by inference, the convention as amended by the second Protocol) enters into force, the penultimate sentence of paragraph (1) of Article 26 is to be read as if that sentence had entered into force on May 30, 1980. This is intended to ensure that any U.S. statutory enactment of source rules for foreign tax credit purposes after May 30, 1980, that were intended by the congress to apply notwithstanding any pre-existing treaty rule to the contrary, would apply under this convention.

The rules of paragraph (4) of Article 26 and of the penultimate sentence of paragraph (1) of Article 26 generally have the same effect. However, it is not intended that the penultimate sentence of paragraph (1) of Article 26 in any way limit or otherwise affect the source rules as determined under paragraph (4) of Article 26.

Finally, paragraph 15 of the Exchange of Notes clarifies that the meaning of the terms “stock or intangible” in paragraph (4) has the meaning ascribed to it in section 865(h) of the Code when the taxpayer elects under that section.

ARTICLE XIV

Article XIV of the protocol amends Article 27 (Nondiscrimination) of the Convention. Paragraph (1) of Article XIV replaces paragraph (1) of Article 27 of the Convention with a new paragraph (1). The new paragraph conforms more closely to the corresponding paragraph in the 1981 U.S. Model. Paragraph 1, as amended, provides that a citizen of one Contracting State may not be subject to taxation or connected requirements in the other Contracting State that are different from, or more burdensome than, the taxes and connected requirements imposed upon a citizen of that other State in the same circumstances. A citizen of a Contracting State is afforded protection under this paragraph even if he is not a resident of either contracting State. The paragraph also provides that the United States need not apply the same taxing regime to an Israeli citizen who is not resident in the United States that it applies to a U.S. citizen who is not resident in the United States because theme persons are not in the same circumstances. A U.S. citizen who is not a resident of the United States is subject to United States tax on his worldwide income, unlike a citizen of Israel who is not U.S. resident. Thus, Article 27 would not entitle an Israeli citizen not resident in the United States to the net basis taxation of U.S. source dividends or other investment income, which applies to a U.S. citizen not resident in the United States. A U.S. citizen who is resident in a third country, however, is entitled, under this paragraph, to the same treatment in Israel as an Israeli citizen who is in similar circumstances.

Paragraph 2 of Article XIV of the Protocol adds a new paragraph (4) to Article 27 (Nondiscrimination). Paragraph (4) specifies that no provision of the Article will prevent either Contracting State from imposing the branch tax described in Article 14A (Branch Tax). Thus, even if the branch tax were judged to violate the provisions of the other paragraphs of the Article, neither contracting State would be constrained from imposing the tax.

During the course of the negotiation of the Second Protocol, understandings were reached regarding the application of Article 27 to two aspects of U.S. tax law. 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 an Israeli resident partner’s share of the partnership income attributable to a U.S. permanent establishment. There is no similar obligation with respect to the distributive share of, a U.S. resident partner. 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 Israeli partnerships, since the law requires that partnerships of both States withhold tax in respect of the distributive shares of non-U.S. partners. In distinguishing between U.S. and Israeli partners, the requirement to withhold on the Israeli 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 may otherwise 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. For the same reasons, it also is understood that these provisions in section 1446 do not violate paragraph (3) of the Article.

The TRA introduced section 367(e)(2) of the Code, which changed the rules for taxing corporations on certain distributions they make in liquidation. Prior to the TRA, corporations were not taxed on distributions of appreciated property in complete liquidation, although non- liquidating distributions of the same property, with several exceptions, resulted in corporate-level tax. In part to eliminate this disparity, the law now generally taxes corporations on the liquidating distribution of appreciated property. The Code provides an exception in the case of distributions by 80 percent or more controlled subsidiaries to their parent corporations, because the assets’ built-in gain will be recognized when the parent sells or distributes the asset. This exception does not apply to distributions to parent corporations that are tax-exempt organizations or, except to the extent provided in regulations, foreign corporations. The policy of the legislation is to collect one corporate-level tax on the liquidating distribution of appreciated property; if and only if that tax can be collected on a subsequent sale or distribution does the legislation defer the tax. It is understood that the inapplicability of the exception to the tax on distributions to foreign parent corporations does not conflict with paragraph (3) of the Article. While a liquidating distribution to a U.S. parent will not be taxed, and, except to the extent provided in regulations, a liquidating distribution to a foreign parent will, paragraph (3) merely prohibits discrimination among corporate taxpayers on the basis of U.S. or foreign stock ownership. Eligibility for the exception to the tax on liquidating distributions for distributions to non-exempt, U.S. corporate parents is not based upon the nationality of the owners of the distributing corporation, but rather is based upon whether such owners would be subject to corporate tax if they subsequently sold or distributed the same property. Thus, the exception does not apply to distributions to persons that would not be so subject — not only foreign corporations, but also tax-exempt organizations.

ARTICLE XV

Article XV of the Protocol amends Article 29 (Exchange of Information) of the Convention, by replacing paragraph (1) of Article 29 with a new paragraph. As amended, paragraph (1) provides for the exchange of information between the competent authorities of the Contracting States. The information to be exchanged is that pertinent for carrying out the provisions of the Convention or the prevention of fraud or evasion in relation to U.S. or Israeli taxes that are covered by 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 for the purpose of carrying out the Convention. The exchange must, however, be for the purpose of preventing fraud or evasion with respect to that tax.

Paragraph (1) also provides assurances that any information exchanged will be treated as secret. Information received may be disclosed only to persons or authorities concerned with the assessment (including judicial determination), collection, or administration of the taxes to which the Article relates. The information must be used by these persons in connection with these designated functions. Persons concerned with the administration of taxes, in the United States, include legislative bodies, such as the tax-writing committees of Congress and the General Accounting Office. Otherwise confidential information may be received by these bodies but only for their use in the performance of their role in overseeing the administration of U.S. tax laws.

ARTICLE XVI

Article XVI of the Protocol amends Article 31 (Entry Into Force) of the Convention, by replacing the rule in subparagraph (b) of Article 31 providing the effective date for taxes other than withholding taxes (which is provided for under subparagraph (a)). Subparagraph (b), as amended, provides alternative effective date rules, depending on the time of the year that the Convention enters into force, according to the provisions of the introductory language of Article 31. If the Convention enters into force prior to July 1 of any calendar year, the Convention will have effect, for taxes other than withholding taxes, for taxable years beginning on or after January 1 of the year in which the Convention enters into force. If, however, the Convention enters into force after June 30 of any calendar year, it will have effect, for taxes other than withholding taxes, for taxable years beginning on or after January 1 of the year following entry into force of the Convention.

ARTICLE XVII

Article XVII provides the rules for the entry into force of the second protocol. The Protocol is subject to ratification by both contracting States. It will enter into force 30 days after the exchange of instruments of ratification, and its provisions will take effect in accordance with the provisions of Article 31 (Entry Into Force) of the Convention.

A special rule in Article XVIII relating to the applicable source rules for U.S. foreign tax credit purposes is described in the explanation of Article 26 (Relief from Double Taxation).

EXCHANGE OF NOTES (PROTOCOL 2)

Two paragraphs in the Exchange of Notes were not described above in connection with Articles of the Protocol.

Paragraph 8 relates to Article 10 (Grants) of the Convention. It clarifies that the failure by Israel to include a grant in the basis of stock or assets for income tax purposes is understood not to mean that the grant is “taxed by Israel”.

Paragraph 16 makes clear that a reference in the Convention to the currency of one of the Contracting States is to be understood to be a reference to the currency as it is named at the time the relevant rule of the Convention is being applied. Thus, the references in Articles 18 (public Entertainers) and 24 (Students and Trainees) to Israeli pounds, are understood today to be a reference to Israeli shekels.