by Yuval Navot
Following months of speculation on the subject, the Israel Tax Authority (the “ITA”) on April 2 published a draft circular addressing Israeli taxation of non-Israeli Internet companies. The central issues addressed in the circular pertain to the attribution of profits to Israel for corporate income tax and Israeli value added tax (“VAT”) purposes. Currently, the guidance is in draft form; it has been circulated to a number of industry participants and professionals to receive feedback.
Below is a summary of the main points addressed in the circular.
In general
The circular provides some general background about the way Internet companies tend to operate in Israel and the concerns the ITA has about the manner in which they are taxed.
The circular points out that there are numerous types of Internet companies connected to Israel, but the circular addresses only companies that provide services via the Internet, with an emphasis on companies that are assisted by a related Israeli company, normally an Israeli subsidiary.
The circular also claims to be in line with a global trend in this area, as the OECD is engaged in a project (known as BEPS) which also takes up this matter in its report on digital economy.
It is interesting to note that the circular does not contain any legislative proposals. Instead, it suggests a new position of the ITA in respect of existing laws and standards. As a result, even a final version of the circular would only constitute the view of the ITA and would not bind the courts in any way.
Corporate income taxes
The relevant issues addressed with respect to corporate income tax are (a) whether a permanent establishment exists in Israel, and (b) how to attribute profits to a permanent establishment in Israel.
It should be noted that the notion of a permanent establishment belongs to the double tax treaty framework. If the non-Israeli company is a resident in a non-treaty country, the standard for income attributable to Israel may be looser. Notwithstanding, it is usually relatively similar.
There are generally two types of permanent establishments that an Internet company can have in Israel. The first is where the company has a “fixed place of business” at its disposal in Israel. The second is where a company has a so-called dependent agent in Israel.
When determining the existence of a fixed place of business, great emphasis was once attached to the location of a company’s server. Perhaps the most significant element of the circular is the marginalizing of server location as a central factor in determining the existence of a permanent establishment. Instead, the circular suggests examining the economic activity of the foreign company in Israel.
The circular proposes that where the “core” of a company’s activity is the operation of an Internet business, the ITA will examine the following factors in seeking to determine the existence of a permanent establishment:
- Whether, in addition to the facility in Israel, the foreign company operates a special website for the use of Israeli customers (language, advertisement, style, currency, etc.).
- Whether the website connects Israeli customers with Israeli vendors.
- The degree of popularity of the website amongst Israeli users.
- Whether the ability to generate income from the site increases as the number and activity of users increase.
- Whether the representatives of the non-Israeli company in Israel are involved in locating customers, collecting data with the assistance of the Israeli facility.
- Whether there is an ongoing connection between the representatives of the non-Israeli company and the Israeli clients with assistance provided by the Israeli facility – for example, helping to organize customer conferences, generating opportunities for presenting new products, development and refinement of the services provided to customers, or provision feedback to the foreign operation on the local market in Israel.
- The scope of the marketing and support services provided in Israel through the local representative.
- Whether the foreign company’s operation in Israel generates a business risk.
It is important to note that if the foreign company makes use of the Israeli facilities of its related company in Israel, unrelated to the business of the Israeli company itself, this could also give rise to a permanent establishment.
Furthermore, if employees of the local Israeli company are engaged in activities of the foreign company, this may give rise to a permanent establishment in Israel. In short, integration between the activity of the foreign company and the Israeli company can lead to the existence of a permanent establishment in Israel.
In respect of the second type of permanent establishment, namely the presence of a dependent agent in Israel, the circular does not suggest any significant changes to the known standard but does offer a somewhat broader interpretation approach.
Very generally, a dependent agent of a foreign company can give rise to a permanent establishment when such agent regularly “concludes” contracts on behalf of the company in Israel. The circular clarifies that the notion of “concluding” a contract includes informal understandings that bind the company and could include negotiations depending on their intensity and regularity.
The circular notes, for example, that authority to fix a price or other commercial terms that bind the company (even if within a predetermined definitive range), or involvement in adjusting a standard form of agreement for the specific requirements of a local client may give rise to a dependent agent permanent establishment.
Attribution of profits
Once a permanent establishment is deemed to exist, it remains to be determined how to attribute profits to the permanent establishment in Israel. The circular adopts the so-called Authorized OECD Approach, which essentially views the permanent establishment as a separate legal entity and examines what profit such an entity would have generated on a stand-alone basis. For this purpose, the circular provides a two stage test:
First, a facts and functions analysis is performed. This analysis involves (a) identifying the significant people functions relevant for establishing which of the company’s assets should be viewed as belonging to the permanent establishment, (b) identifying the significant people functions relevant for establishing what risk should be viewed as belonging to the permanent establishment, (c) identifying other functions of the permanent establishment, and (d) identifying and characterizing the internal transactions.
The second stage involves the transfer pricing under the framework of regarding the permanent establishment as a standalone business.
The existence of a permanent establishment would require opening a separate tax file and the income, gains, and losses of the permanent establishment cannot be commingled with those of the local Israeli company.
The circular notes that the ITA has authority to approach non-Israeli companies to obtain information regarding the activities in Israel that would serve to determine whether there is an Israeli permanent establishment and the proper profits attribution to such permanent establishment.
VAT
The circular also addresses the question of VAT, which is currently set at a rate of 18 percent.
In the VAT context, the relevant question becomes whether the company has “business activity” in Israel that requires registration for VAT as a dealer. The circular suggests a number of factors to consider in connection with Internet companies:
- Whether the services are provided to Israelis customers with respect to Israeli users (e.g. advertisement targeted to Israeli audience).
- Whether the services to Israeli customers are directed to Israeli users.
- Whether the service is actually provided in Israel, since for the most part the service is provided through the display of content on Israeli computers and generally through Israeli websites.
- Whether marketing functions or customer support is done from Israel through related companies.
- The services provided by the foreign company are utilized in Israel.
The circular also provides a couple of examples:
If a foreign company operates an Internet search engine, it will be obligated to register for VAT in respect of the income generated from Israeli customers that are directed to Israeli consumers.
Another example provides that a foreign company operating a website for booking hotels in Israel would be required to register as a “dealer” for VAT purposes and charge VAT on its transactions with Israeli residents.
Finally, it is important to note that where a permanent establishment is deemed to exist for income tax purposes, the circular adopts a presumption that the company will need to register for VAT as well.
—Yuval Navot is a partner with Herzog, Fox & Neeman, Tel Aviv ([email protected]).
Copyright 2015 Yuval Navot. All rights reserved.
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