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 (as defined in paragraph 7) of an enterprise of one Contracting State may not be taxed by the other Contracting State unless the enterprise carries on business in that other Contracting State through a permanent establishment (as defined in Article 5 (Permanent Establishment)) situated there. When that condition is met, the State in which the permanent establishment is situated may tax the enterprise on the income that is attributable to the permanent establishment, but only on a net basis. 　　Under certain circumstances, the State in which the permanent establishment exists may also tax income of the enterprise attributable to sales in that other State of goods or merchandise of the same kind as those sold through the permanent establishment, or to other business transactions carried on in that other State which are of the same or similar kind as those effected through the permanent establishment. These rules are of a type known as "limited force of attraction" rules. 　　 This limited force of attraction rule is similar to, but narrower than, a rule found in the U.N. Model. Under the rule in the U.N. Model, if an enterprise of one Contracting State derives income from the sale of goods or the carrying on of other business activities through a permanent establishment situated in the other Contracting State, income derived directly by the enterprise (i.e., not through the permanent establishment) from the sale of goods of the same or similar kind as those sold through the permanent establishment or from the carrying on of activities of the same or similar kind as those carried on through the permanent establishment may be attributed to the permanent establishment. Countries that insist on including a limited force of attraction rule see it as a means of preventing avoidance of their tax at source. The force of attraction rule in this Convention focuses on its anti-abuse function. Its application is limited to situations in which it can be shown that the transaction giving rise to the income was carried out outside the permanent establishment in order to avoid taxation in the country in which the permanent establishment is situated. For example, if the Tallinn office of a U.S. consulting firm provides certain services to small companies in Estonia and a very large Estonian company requires similar services but on a scale too large for the permanent establishment to handle, the Estonian company might enter into a contract with the consulting firm's home office in the United States to provide those services directly. The income from that transaction would not be attributed to the permanent establishment because it could not be shown that the transaction was structured through the U.S. office in order to avoid Estonian tax. If, however, some small Estonian companies are served by the Tallinn office and other similar-sized companies are served directly from the United States, it might be possible to show that services were carried out through the home office to avoid Estonian tax. If such a case were made, the income from these contracts with the home office would be attributed to the permanent establishment. 　　The limited force of attraction rule in this Convention is narrower than the rule of Code section 864(c)(3). Paragraph 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 an independent enterprise engaged in the same or similar activities under the same or similar circumstances. This language incorporates the arm's length standard for purposes of determining the profits attributable to a permanent establishment. The computation of business profits attributable to a permanent establishment under this paragraph is subject to the rules of paragraph 3 for the allowance of expenses incurred for the purposes of earning the profits. 　　The "attributable to" concept of paragraph 2 is analogous but not entirely equivalent to the "effectively connected" concept in Code section 864(c). The profits attributable to a permanent establishment may be from sources within or without a Contracting State. 　　It is understood that the business profits attributed to a permanent establishment include only those profits derived from that permanent establishment's assets or activities. This rule is consistent with the "asset-use" and "business activities" test of Code section 864(c)(2). Thus, the limited force of attraction rule of Code section 864(c)(3) is not incorporated into paragraph 2. 　　This Article does not contain a provision corresponding to paragraph 4 of Article 7 of the OECD Model. That paragraph provides that a Contracting State in certain circumstances may determine the profits attributable to a permanent establishment on the basis of an apportionment of the total profits of the enterprise. The inclusion of such a paragraph is unnecessary. Paragraphs 2 and 3 of Article 7 authorize the use of such approaches independently of paragraph4 of Article 7 of the OECD Model because total profits methods are acceptable methods for determining the arm's length profits of an enterprise under Article 9. Any such approach, however, must be designed to approximate an arm's length result. Accordingly, it is understood that under paragraph 2 of the Convention, it is permissible to use methods other than separate accounting to estimate the arm's length profits of a permanent establishment where it is necessary to do so for practical reasons, such as when the affairs of the permanent establishment are so closely bound up with those of the head office that it would be impossible to disentangle them on any strict basis of accounts. Paragraph 3 　　This paragraph is in substance the same as paragraph 3 of Article 7 of the U.S. Model. Paragraph 3 provides that in determining the business profits of a permanent establishment, deductions shall be allowed for the expenses incurred for the purposes of the permanent establishment, ensuring that business profits will be taxed on a net basis. Whereas the U.S. Model explicitly states that deductions are not limited to expenses incurred exclusively for the purposes of the permanent establishment, in this treaty, like the OECD model, it is implicitly understood that there will be allowed a reasonable allocation to the permanent establishment of expenses incurred by the enterprise, whether those expenses were incurred for purposes of the enterprise as a whole, or they were incurred for the part of the enterprise that includes the permanent establishment, see paragraph 16 of the Commentaries to Article 7 of the OECD Model. Deductions are to be allowed regardless of which accounting unit of the enterprise books the expenses, so long as they are incurred for the purposes of the permanent establishment. For example, a portion of the interest expense recorded on the books of the home office in one State may be deducted by a permanent establishment in the other if properly allocable thereto. The paragraph specifies that the expenses that may be considered to be incurred for the purposes of the permanent establishment are expenses for research and development, interest and other similar expenses, as well as a reasonable amount of executive and general administrative expenses. This rule permits (but does not require) each Contracting State to apply the type of expense allocation rules provided by U.S. law (such as in Treas. Reg. sections 1.861-8 and 1.882-5). 　　Paragraph 3 does not permit a deduction for expenses charged to a permanent establishment by another unit of the enterprise. Thus, a permanent establishment may not deduct a royalty deemed paid to the head office. Similarly, a permanent establishment may not increase its business profits by the amount of any notional fees for ancillary services performed for another unit of the enterprise, but also should not receive a deduction for the expense of providing such services, since those expenses would be incurred for purposes of a business unit other than the permanent establishment. 　　The last sentence of the paragraph, which is neither in the U.S. Model nor in the OECD Model, allows each Contracting State, consistent with its law, to impose limitations on the deductions taken by the permanent establishment as long as the limitations are consistent with the concept of net income. This language was provided at the request of the Estonian delegation. The language allows the United States and Estonia to place limits on certain deductions, for example, entertainment expenses. However, it would not permit the Contracting States to deny a deduction for wages or interest expenses since such expenses are so fundamental that denial of deductions would be inconsistent with the concept of net income. Paragraph 4 　　Paragraph 4 permits the tax authorities of a Contracting State to apply the provisions of internal law in determining tax liability in cases where the information available to the competent authority is not adequate to measure accurately the profits of a permanent establishment. The Internal Revenue Service would have this power even in the absence of such a specific provision. The determination of profits in such cases, based on the available information, must be done consistently with the principles of this Article, i.e., it must seek to reflect arm's length pricing and appropriate deductions of expenses. Paragraph 5 　　Paragraph 5 provides that no business profits can be attributed to a permanent establishment merely because it purchases goods or merchandise for the enterprise of which it is a part. This paragraph is identical to paragraph 4 of the U.S. Model. This rule applies only to an office that performs functions for the enterprise in addition to purchasing. The income attribution issue does not arise if the sole activity of the permanent establishment is the purchase of goods or merchandise because such activity does not give rise to a permanent establishment under Article 5 (Permanent Establishment). A common situation in which paragraph 4 is relevant is one in which a permanent establishment purchases raw materials for the enterprise's manufacturing operation conducted outside the United States and sells the manufactured product. While business profits may be attributable to the permanent establishment with respect to its sales activities, no profits are attributable to it with respect to its purchasing activities. Paragraph 6 　　This paragraph tracks paragraph 5 of Article 7 of the U.S. Model, providing that profits shall be determined by the same method each year, unless there is good reason to change the method used. This rule assures consistent tax treatment over time for permanent establishments. 　　It limits the ability of both the Contracting State and the enterprise to change accounting methods to be applied to the permanent establishment. It does not, however, restrict a Contracting State from imposing additional requirements, such as the rules under Code section 481, to prevent amounts from being duplicated or omitted following a change in accounting method. Paragraph 7 　　The term "business profits" is broadly defined in paragraph 7 to mean income derived from any trade or business. Specific examples that are not meant to be comprehensive include profits from manufacturing, mercantile, fishing, transportation, communications or extractive activities. Business profits also include income from the furnishing of the personal services of other persons, but as the second sentence of paragraph 7 describes, business profits do not include compensation received by an individual for the performance of personal services, whether as an employee or in an independent capacity. Thus, a consulting firm resident in one State whose employees perform services in the other State through a permanent establishment may be taxed in that other State on a net basis under Article 7. The salaries of the employees, however, will be subject to the rules of Article 15 (Dependent Personal Services). 　　In accordance with this broad definition, the term "business profits" includes income attributable to notional principal contracts and other financial instruments to the extent that the income is attributable to a trade or business of dealing in such instruments, or is otherwise related to a trade or business (as in the case of a notional principal contract entered into for the purpose of hedging currency risk arising from an active trade or business). Any other income derived from such instruments is, unless specifically covered in another article, dealt with under Article 21 (Other Income). 　　Unlike the U.S. Model and the OECD Model, income derived by an enterprise from the rental of tangible personal property is not included in this Article, but instead (with the exception of container leasing which is included in Article 21 (Other Income) and ship and aircraft leasing　covered by Article 8 ( Shipping and Air Transport)) is included in Article 12 (Royalties). . Paragraph 8 　　Paragraph 8 coordinates the provisions of Article 7 and other provisions of the Convention. Under this paragraph, when business profits include items of income that are dealt with separately under other articles of the Convention, the provisions of those articles will, except when they specifically provide to the contrary, take precedence over the provisions of Article 7. For example, the taxation of dividends will be determined by the rules of Article 10 (Dividends), and not by Article 7, except where, as provided in paragraph 4 of Article 10, the dividend is attributable to a permanent establishment or fixed base. In the latter case the provisions of Articles 7 or 14 (Independent Personal Services) apply. Thus, an enterprise of one State deriving dividends from the other State may not rely on Article 7 to exempt those dividends from tax at source if they are not attributable to a permanent establishment of the enterprise in the other State. By the same token, if the dividends are attributable to a permanent establishment in the other State, the dividends may be taxed on a net income basis at the source State's full corporate tax rate, rather than on a gross basis under Article 10 (Dividends). 　　As provided in Article 8 (Shipping and Air Transport), income derived from shipping and air transport activities in international traffic described in that Article is taxable only in the country of residence of the enterprise regardless of whether it is attributable to a permanent establishment situated in the source State. Paragraph 9 　　Paragraph 9 incorporates into the Convention the rule of Code section 864(c)(6). Like the Code section on which it is based, paragraph 8 provides that any income or gain attributable to a permanent establishment or a fixed base during its existence is taxable in the Contracting State where the permanent establishment or fixed base is situated, even if the payment of that income or gain is deferred until after the permanent establishment or fixed base ceases to exist. This rule applies with respect to paragraphs 1 and 2 of Article 7 (Business Profits), paragraph 6 of Article 10 (Dividends), paragraph 5 of Articles 11 (Interest), paragraph 4 of 12 (Royalties), paragraph 3 of Article 13 (Gains), Article 14 (Independent Personal Services) and paragraph 2 of Article 21 (Other Income). 　　The effect of this rule can be illustrated by the following example. Assume a company that is a resident of Estonia and that maintains a permanent establishment in the United States winds up the permanent establishment's business and sells the permanent establishment's inventory and assets to a U.S. buyer at the end of year 1 in exchange for an interest-bearing installment obligation payable in full at the end of year 3. Despite the fact that Article 13's threshold requirement for U.S. taxation is not met in year 3 because the company has no permanent establishment in the United States, the United States may tax the deferred income payment recognized by the company in year 3. Relation to Other Articles 　　This Article is subject to the saving clause of paragraph 4 of Article 1 (General Scope) of the Model. Thus, if a citizen of the United States who is a resident of Estonia under the treaty derives business profits from the United States that are not attributable to a permanent establishment in the United States, the United States may, subject to the special foreign tax credit rules of paragraph 3 of Article 23 (Relief from Double Taxation), tax those profits, notwithstanding the provision of paragraph 1 of this Article which would exempt the income from U.S. tax. 　　The benefits of this Article are also subject to Article 22 (Limitation on Benefits). Thus,　an enterprise of Estonia 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 22. ARTICLE 8 Shipping and Air Transport 　　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(g) of Article 3 (General Definitions). The taxation of gains from the alienation of ships, aircraft or containers is not dealt with in this Article but in paragraph 4 of Article 13 (Gains). 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 8 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 the other State, that State 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 establishments 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 further 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 that are closely related to those activities. First, income of an enterprise of a Contracting State from the rental of ships or aircraft on a full basis (i.e., with crew) when such ships or aircraft are used in international traffic (i.e., when operated by a resident of one of the contracting states) 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 ships or aircraft are operated in international traffic (i.e., when operated by a resident of one of the contracting states), and the income is incidental to other income of the lessor from the operation of ships or aircraft in international traffic. Thus, the coverage of Article 8 of the Convention is generally consistent with Article 8 of the OECD Model although narrower than the U.S. Model, which also covers rentals from bareboat leasing that are not incidental to the operation of ships or aircraft by the lessee. As discussed above, the classes of income derived from the rental of ships and air transport not included in this Article are included in Article 12 (Royalties) or Article 7 (Business Profits). 　　Paragraph 2 also clarifies, consistent with the Commentary to Article 8 of the OECD Model, that income earned by an enterprise from the inland transport of property or passengers within either Contracting State falls within Article 8 if the transport is undertaken as part of the international transport of property or passengers by the enterprise. Thus, if a U.S. shipping company contracts to carry property from the other State 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 the other State (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 income from lighterage undertaken as part of the international transport of goods. 　　Finally, certain non-transport activities that are an integral part of the services performed　by a transport company are understood to be covered in paragraph 1, though they are not specified in paragraph 2. These include, for example, the performance of some maintenance or catering services by one airline for another airline, if these services are incidental to the provision of those services by the airline for itself. 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 that is engaged in the operation of ships and aircraft derived from the use, maintenance or rental of containers (including equipment for their transport) that are used for the transport of goods in international traffic are exempt from tax in the other Contracting State. Thus, this paragraph applies only to income from the use, maintenance or rental of containers that is incidental to other income from international traffic. This differs from the U.S. Model in which both incidental and nonincidental income from the rental of containers is included in Article 8. 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. Relation to Other Articles 　　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 22 (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 Estonia 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 3 of Article 23 (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.)