The UK faced the same dilemma in the 1960s when oil was found in the North Sea.
Now that large quantities of gas have been discovered off the coast of Israel, Israeli taxation rules in this regard must be examined because they are not in good shape. Surprisingly, the main issue is whether Israel has any right to tax it. If so, what is the tax treatment?
The UK faced the same dilemma in the 1960s when oil was found in the North Sea. Did it have any right to tax this enormous source of income?
TIMETABLE FOR COMMENTS
In Israel, the Sheshinsky Commission is looking into the subject and is expected to submit its findings to the government by October 31, 2010. The public is invited to submit comments to the Sheshinsky Commission by August 15, 2010. This is an open letter to the Sheshinsky Commission. There are a number of issues that need to be addressed:
WHERE IS ISRAEL?
The Israeli Income Tax Ordinance states that income accruing or derived in Israel is subject to Israeli income taxation. So where is Israel? Can Israel tax income from a gas field around 100 kilometers off the Mediterranean coast? This is, of course, a politically loaded question, but I‘ll do my best to keep to Israeli and international taxation considerations.
Here‘s how the term Israel is defined in Section 1 of the Israeli Interpretation Ordinance: ‘‘Including its coastal waters.‘‘ Here‘s how coastal waters are defined in Section 3 of the Interpretation Law, 1981: ‘‘The 12- nautical-mile-wide band of sea along the length of Israel‘s coast.‘‘
So there seems little doubt that income attributable to business done onshore in Israel or within 12 nautical miles from the Israeli coast falls within Israel‘s territory for tax purposes.
The issue is less certain beyond 12 nautical miles on the continental shelf. Here‘s how Section 1 of the Israeli Underwater Territories Law, 1953, defines the underwater territory falling within the territory of the State of Israel:
(a) ‘‘The territory of the State of Israel shall include the seabed and the subsoil of the underwater areas adjacent to Israel‘s coast, which are outside the territorial waters, wherever the depth of the water facilitates the exploitation of natural resources in those areas.
(b) Nothing stated in subsection (a) above shall affect the characterization of the water above those underwater areas, and outside Israeli territorial waters, as high seas.‘‘
This means that the State of Israel may claim territorial rights regarding a seabed area that is located beyond its territorial waters, wherever it is possible to exploit natural resources in those areas (i.e., on the continental shelf in practice). The Underwater Territories Law, 1953, also emphasizes that the waters above the underwater areas represent high seas.
The Geneva Convention on the Continental Shelf (1958) dealt with the issue of countries‘ sovereignty over the continental shelf and indicated the applicable customary international law. The Geneva Convention prescribes in Articles 2 and 3 the following: ‘‘The coastal State exercise over the continental shelf sovereign rights for the purpose exploring it and exploiting its natural resources. The rights of the coastal State over the continental shelf do not affect the legal status of superjacent waters as high seas, or that of the air space above those waters.‘‘
Accordingly, Israel does not have ‘‘sovereignty‘‘ over the area of the underwater shelf, merely ‘‘sovereign rights,‘‘ which are restricted rights for purposes of exploiting natural resources. Therefore, the seas above the continental shelf and outside of the territorial waters of the State are viewed as high seas that are not.
WHAT DOES ALL THIS MEAN FOR AN OPERATOR?
It would appear that the current Israeli Underwater Territories Law, 1953, is in accordance with the Geneva Convention.
Exploitation of natural resources on or below the seabed any distance off the Israeli coast falls within Israeli sovereign rights.
Nevertheless, there are other situations. There are also many uncertainties that the Sheshinsky Commission will need to address. These include:
Sovereign rights: It is unclear to some whether ‘‘sovereign rights‘‘ include taxation rights. The Israel Tax Authority claims that sovereign rights include taxation rights.
Taxation rights: If sovereign rights include taxation rights, does this apply to all taxes: income tax, VAT, customs, etc?
Revenue royalty: Presumably, the petroleum commissioner will claim that Israel has full sovereign rights to collect the royalty (tax?) of 12.5 percent of oil and gas revenues.
The rate currently is subject to debate. The resulting rate needs to be in harmony with the income-tax system; the royalty must be deductible as an income-tax expense of the operator.
Continental shelf: How far does the Israeli continental shelf extend? For example, does it extend all the way to Gibraltar? Exploration: There is a difference between exploration (looking for oil or gas) and exploitation (after commercial quantities are found, extracting and selling them). The current Israeli Underwater Territories Law, 1953, refers to natural-resource exploitation but is silent about exploration.
This implies Israel has never claimed any sovereign rights over exploration of/below the seabed more than 12 nautical miles off the Israeli coast. Is income from exploration on and above the seabed more than 12 nautical miles off the Israeli coast exempt from Israeli taxes?
Above seabed: Are all activities above the seabed on a ship or a rig more than 12 nautical miles off the Israeli coast (i.e., on the high seas) exempt from Israeli taxes under Israeli and international law? Or if the legs of the rig are anchored on the seabed, can Israel tax them? This question applies to a wide variety of oil and gas activities above the seabed on the high seas: exploration, exploitation, processing (you can‘t put crude oil in your car, it needs processing; so does gas), sending food and other supplies to the rig by ship, etc.
Pipelines: With regard to pipelines for shipping oil or gas ashore from the sea, is the resulting income taxable to the extent a pipeline is buried in the seabed and exempt to the extent a pipeline is above the seabed more than 12 nautical miles off the Israeli coast?
Aerial activities: Are aerial activities (clearly above the seabed) more than 12 nautical miles off the Israeli coast exempt from Israeli tax; for example, helicopter supplies to oil and gas rigs.
Mixed activities: What are the applicable transfer pricing rules for allocating income between different activities and locations if they are carried out by different entities in a group? Section 85A of the Income Tax Ordinance requires market pricing, but different methodologies exist.
Tax breaks: Since oil and gas are extremely important to the State of Israel, should the State grant tax reductions or exemptions for oil and gas activities? In the past they were said to be available, but now they generally are not, under the Law for the Encouragement of Capital Investments, 1959.
Depletion and amortization allowances are available for oil and gas under the Israeli Petroleum Law, 1952, but these partly accelerate depreciation, which would be claimed sooner or later anyway.
Tax treaties: These are the joker in the pack. Israel‘s tax treaties with 50 other countries contain differing definitions of ‘‘Israel‘‘ and ‘‘permanent establishment,‘‘ with differing tax consequences. A permanent establishment is, in principle, a fixed place of business or a dependent agent; in practice, it is hard to know if a ship or helicopter operation falls into these categories.
It might be argued that tax treaties cannot impose an Israeli tax liability where none existed before, without each country involved agreeing to this. On the other hand, it might be argued that tax treaties merely clarify things. In practice, review is needed on a case-by-case basis where a treaty applies.
Equipment: Issues arise. If the equipment is, for example, 10 years old when equipment is imported into Israel, and the depreciation rate is 15% on a straight-line basis, does that depreciation start when the equipment is first put into service in Israel (now), or abroad (10 years ago, considered fully depreciated)?
Withholding taxes: Israeli banks are required to withhold 25% tax at source from payments remitted abroad, unless an exemption or tax-treaty relief is requested upfront from the Israeli payer‘s tax office. This applies to the operation as a whole, as well as interest, royalty, leasing and rental payments (e.g., ship and aircraft chartering, unless the ship or aircraft ply international lines).
This effectively subjects the foreign recipient to an immediate tax audit, to the intense annoyance of everyone, unless the foreign recipient forces the Israeli payor to absorb the withholding tax. If it does, the result may be 33.3% withholding tax on a grossed up basis (a net-of-tax payment of $100 equates to $133.33 before the withholding tax). If withholding tax is circumvented, the payor cannot deduct the expense and may incur penalties, etc. This also does not encourage international cooperation.
WHAT ABOUT THE WORKERS?
Many employees and management personnel in the oil and gas sector will be experienced expats from abroad.
The Sheshinsky Commission will need to address a number of issues including those discussed below
When the personnel work at sea, they will face the same above-mentioned Israeli tax uncertainties.
If they are resident in a different country to their employing company, will they be taxed in Israel? (Partial answer: Yes, if they are US residents under the US-Israel Tax Treaty; No, under most other tax treaties, if certain conditions are met and they are present under 183 days in Israel, as defined in the relevant tax treaty).
If they come ashore to rest in Israel (e.g., two weeks working at sea, two weeks resting in an Israeli port city), will they be exempt? Or should they take their rest in another nearby country? Other issues come to mind, too. Will Israeli and foreign employees enjoy National Insurance Institute coverage, for example, following a work accident on an oil or gas rig at sea? Will foreign personnel readily receive work permits? Will the 20% foreign-workers payroll levy be imposed? Will foreign pension contributions (for example, to a US 401k plan) be recognized for Israeli tax deduction or credit purposes? Will there be double taxation in Israel and abroad of stock-option benefits? Will Israeli resident personnel enjoy the special tax deductions and tax rates for overseas work if they work on a rig, ship or aircraft?
A SHORT SUMMARY
To sum up, the Sheshinsky Commission will need to address the above-mentioned issues and plenty more (e.g., residency, tax registration and administration, VAT accounting, etc.) if the new oil and tax regime is to raise taxes without deterring rapid natural resource exploration and exploitation.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
Leon Harris is an international tax specialist at Harris Consulting & Tax Ltd.