Tax on Foreign Online Companies That Pass Over?

Leon Harris

On April 2, the Israeli Tax Authority (ITA) published an aggressive draft Circular aimed at foreign online service companies.

Main Issue:

In the draft Circular, the ITA seeks to extend its jurisdiction and to start taxing foreign online service companies if their activities have an Israeli link.

Currently, the generally accepted principle is for a country like Israel to tax foreign companies that do business IN Israel, but not foreign companies that do business WITH Israel from abroad. This is enshrined in the Israeli Income Tax Ordinance (Sections 2 & 4A).

The problem is that foreign companies operating abroad in cyberspace may not think they are doing business IN Israel at all.

The OECD is formulating its own action plan for dealing with online operations as part of its Base Erosion Profits Shifting (BEPS) program.  Israel is a member of the OECD.

Current Tax Treaty Rules:

The draft Circular points out that if a foreign  company is resident in a country that has a tax treaty with Israel, any business it does IN Israel is only taxable in Israel if the foreign company has a  permanent establishment (PE) in Israel, namely: (1) a fixed place of business, or (2) a dependent agent – see below.

However, there are certain “auxiliary or preparatory” exceptions to the PE definition in each treaty, which the draft ITA Circular now wants to curtail.

Currently, the standard rate of company tax is 26.5%.

ITA Position – Fixed place of Business

The draft Circular says that ecommerce sales take place where the server supporting a website is situated. This is based on the OECD model treaty commentary of July 2014.

The draft ITA Circular cites the OECD commentary and claims the following online “core” activities may give rise to a PE in Israel:

  • Part of the facility is in Israel – the foreign entity operates a website adapted for use by Israeli customers (language, adverts, style, currency, etc);
  • The website links an Israeli customer to Israeli suppliers (OECD commentary directly rejects this, see below);
  • Highly popular usage by Israeli users;
  • The ability to make a profit from the site rises as the number of users and their activity rises;
  • Representatives of the foreign entity in Israel are involved in looking for clients or collecting information, aided by a facility in Israel;
  • Client relationship management – maintaining ongoing contact between representatives of the foreign entity and the Israeli client, aided by the Israeli facility. This may be, for example, by organizing client conferences, providing feedback on the foreign enterprise in the Israeli market, etc;
  • Substantial marketing and support services provided in Israel by an Israeli representative of a foreign enterprise;
  • Facilities of an Israeli resident company are placed at the disposal of a foreign company, are used by the foreign company to produce income which is not income of the Israeli company;
  • An individual is employed formally by an Israeli resident company, but works according to instructions of the foreign company.  The extent of involvement of the foreign company in recruitment and employment terms may make it a de facto employer with a PE in Israel.
  • Significant digital presence criteria found in in the draft BEPS Action 1 report of the OECD (“Addressing the Tax Challenges of the Digital Economy”) published on March 24, 2014: substantial number of contracts signed, services consumed or payments made in Israel.

Our Comments – Fixed place of Business:

  • Business With Israel: Nearly all examples in the draft ITA Circular break the cardinal rule of not taxing foreigners who do business WITH Israeli customers from abroad.
  • Overseas Services: According to the OECD model treaty commentary (Para. 42.18 regarding Article 5): “All member states (i.e. including Israel) agree that a State should not have source taxation rights on income derived from the provision of services performed by a non-resident outside that state”.
  • OECD Examples – PE: The draft Circular should have quoted examples of core functions according to the OECD: “the conclusion of the contract with the customer, the processing of the payment and the delivery of the products are performed automatically through the equipment located there (Para. 42.9 regarding Article 5).
  • OECD Examples – No PE: The draft Circular overlooks the examples of (non-taxable) auxiliary or preparatory activities according to the OECD (Para. 42.7 regarding Article 5): (1) providing a communications link between suppliers and customers, (2) advertising of goods or services, (3), relaying information through a mirror server for security and efficiency purposes, (4) gathering market data for the enterprise.
  • Superseded: The draft Circular quotes proposals on “Significant Digital Presence” in the draft BEPS Action 1 report published by the OECD on March 24, 2014. These proposals were rejected by OECD members and dropped from the final Action 1 report of September 16, 2014.
  • BEPS Action 7: The OECD switched to BEPS Action 7: Preventing The Artificial Avoidance of PE Status, in a discussion draft dated October 31, 2014. The Discussion Draft offers several alternatives that deem a PE to exist if storage and delivery activities are not preparatory or auxiliary.  The draft ITA Circular should have mentioned this.
  • Flaws: Language, currency and popularity are simply not tax criteria.
  • Israeli exporters: If other countries adopt reciprocal tax positions against Israeli online operators, this would be disastrous for the start-up nation.
  • Subsidiary Company Not PE: The draft Circular overlooks the rule found in the OECD model treaty (Article 5(7)) and Israel’s tax treaties that control by one company over another shall not of itself constitute for either company a permanent establishment of the other.

ITA Position – Dependent Agent:

The draft Circular points out that a PE arises where a person — other than an agent of an independent status — is acting on behalf of a foreign enterprise and has, and habitually exercises, in Israel an authority to conclude contracts in the name of the foreign enterprise. This reflects Article 5(5) of the OECD model tax treaty.

The draft Circular says that signs of involvement of an Israeli agent in the formulation a contract should be reviewed to see if there is a PE.

Our Comments – Dependent Agent:

  • Conclusion not involvement: The model tax treaty and other treaties deem an agent to be dependent if the agent CONCLUDES contracts, not just gets involved in their formulation.

Attribution of profits to a PE:

The draft Circular cites the 2010 OECD Report on the Attribution of Profits to Permanent Establishments. This involves allocating profits according to “significant people functions”, when conducting a transfer pricing study and reviewing functions, assets and risks.

The ITA claims it can demand information from  foreign entities (ITO Section 135) including the financial statements of a foreign company that derived profits from a PE in Israel .

VAT Aspects:

The draft Circular quotes provisions in the VAT Law which impose VAT on services provided in Israel or to Israeli residents or regarding assets in Israel (VAT Law Sec. 15(a)).

The emphasis is on services aimed at Israeli residents and consumed in Israel.

Currently, the standard Israeli VAT rate is 18%.

According to the draft Circular, the following are examples in which a foreign entity is obliged to register for Israeli VAT purposes:

  • A foreign entity which operates a search engine must register regarding income from publicity services to Israeli clients aimed at Israeli consumers or users;
  • A foreign entity that operates a website for ordering accommodation at hotels or guest houses in Israel must register regarding revenues from accommodation orders by Israeli consumers.

Comments regarding VAT Aspects:

  • We wonder who they mean and why…..
  • Until now, the ITA has rarely enforced VAT for foreign service providers, such as lawyers or accountants who provide advice to Israeli residents from abroad. Will this now change, but only for online operators?

General comments:

  • Although the public is invited to comment on the discussion draft, it is unclear where to send the comments or what will happen to them.
  • Such major changes appear to breach Israel’s tax treaty obligations and OECD obligations. They ought to be debated  by the Knesset (Israeli Parliament).
  • There is no commencement date. Will these changes impose retroactive taxation, interest and penalties? How far back? Civil or criminal penalties?


What should the ITA do now?

We believe Israel should wait for final OECD pronouncements expected later this year. They aim to share out the international cake more fairly.

What should multinationals do now?

In the short term, MNCs should check if they face potential double taxation, and if so, address/challenge it. They should consider using local Israeli subsidiaries where relevant for appropriate arm’s-length consideration….

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

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The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd


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