The Israeli Tax Authority has just issued a tough tax ruling dealing with taxing a foreign company on profits from clients in Israel (6631/16).

The Facts of the Ruling:

According to the Ruling, Company X is a company resident in a country that has no tax treaty with Israel (perhaps offshore). It provides international cargo, logistic warehousing and international money transfers.

Company Y is an unrelated global settlements company that provides settlements and money transfer services in various countries including Israel pursuant to a representation agreement.

In order to provide its services, Company X uses subcontractors in Israel, approved currency dealers that are unrelated to Companies X and Y, to act as points of sale (endpoints) in the ordinary course of their business. These endpoints are a platform for providing service and enabling codes for withdrawing cash deposited at another endpoint in Israel or abroad.

Company X provides various services from outside Israel relating to money transfers, including transacting with Company Y, setting up and running computer servers outside Israel dedicated to money transfers, running client service call centers outside Israel approved by Company Y, approving  endpoint transactions and credit, supplying publicity materials to the endpoints.

Company X had to set up an Israeli subsidiary to deal with Israeli regulatory requirements, employ compliance officers, collect Israeli market data, check the financial strength of the endpoints, distribute publicity materials and oversee the endpoints.

What is the business model? Customers take cash to the endpoint. The endpoint forwards the cash, takes its commission, and pays the rest to Company X. Company X forwards the cash Company Y for settlement and takes its commission, so does Company Y.

What was decided in the Ruling?

Because Company generates revenues from international money transfers by means of its Israeli subsidiary and the endpoints in Israel for Israeli clients, Company X is deemed to generate revenues in Israel.

The Israeli taxable profit is to be calculated on a pro rata basis: global profit related to Israeli activity multiplied by expenses incurred in Israel, divided by global expenses related to Israel.

The regular rate of company tax applies to the resulting taxable profit, 25% at present.

Israeli tax law principles apply. Collection of the tax will be by tax withheld by customers or by Company X paying monthly tax installments. Company X must file annual tax returns reporting the above.

Comments:

This Ruling has caused a stir. The Ruling departs from the cardinal rule of international taxation that foreign companies should only be taxed in Israel if they do business IN Israel, not merely WITH Israel from abroad.

The Ruling comes in the wake of Israeli and international efforts to collect more tax from multinational groups. The OECD has initiated a campaign against so called “base erosion and profit shifting” (BEPS) which addresses the shifting of profits offshore by multinationals.

In this Ruling, it is notable that Company X is resident in a country that does not have a tax treaty with Israel. If a treaty had applied, Company X should only be taxable in Israel if it has a permanent establishment (PE) in Israel, i.e. a fixed place of business or dependent agent. The Israeli Tax Authority has not tried to assert that Company X has a PE in Israel.

It is unclear why the Israeli Tax Authority didn’t make do with taxing the Israeli subsidiary company of Company X.

And the method of calculating the taxable Israeli profit, based on the Israeli share of costs does not appear to correspond to market-based arm’s length principles – it is a mathematical formula which may prove difficult to implement. How do you estimate global expenses related to Israel if Company X has direct and indirect pools of costs in many countries?

Our suggestion to other multinational groups with Israeli clients is to do business with them via a company resident in a country that has a tax treaty with Israel, and to be mindful of the recent OECD BEPS rules. Israel is a member of the OECD and, hence, bound by tax treaties and OECD obligations.

As always, consult experienced tax advisors in each country at an early stage in specific cases.