This April 11 2016, after nearly a year of speculation, the tax authorities of Israel presented their final Circular regarding the taxation of foreign companies providing services through the internet to an audience in Israel. 

Against the backdrop of global “public and political criticism regarding the failure to tax giant multinationals” the Tax Commissioner of Israel, Moshe Asher, early in 2015 already explained his intended approach in a draft of this Circular.  At that occasion he pointed out that the need for effective taxation of the digital economy has been one of the prime concerns of OECD in its fights against Base Erosion Profit Shifting (BEPS).

The final Circular redefines what is considered a taxable “presence” of a foreign internet company in Israel.

The Circular also addresses the charge of VAT, which currently stands in Israel at a rate of 17 percent, on online transactions. Amendments to VAT law have been proposed in parallel, and once accepted would obligate foreign corporations which maintain digital business activity in relation to the Israeli market to register for Value Added Tax purposes.

Corporate Income Tax

A corporation resident of a tax treaty country signatory on a tax treaty with Israel will be taxable in Israel when activity is being performed though ‘permanent presence’ or 'representative'.

The actual presence of representation, the deemed presence of such a permanent establishment or a presence by way of determination of various elements such as where the server presence, use of office space in Israel by the foreign company provided by third parties or related local parties. Also preparatory and auxiliary activities in Israel, such as sales and marketing activities, by other parties or related parties may be considered a permanent establishment of the foreign internet company.

A mix of activities by a foreign internet company and a local (related) company in Israel – even if incidental - could potentially lead to taxation of a presumed economic presence of the foreign company. In respect of a ‘dependent agent’ in Israel, the Circular does favor a broader approach of interpretation than current global views. The Circular promotes a view that the "dealing with contracts by a representative for the foreign company" would include the managing of informal understandings binding the foreign company, which would include the handling of initial negotiations with potential clients depending on their substance and frequency.

ITA has authority to demand of domestic related party companies to obtain information regarding the activities in Israel, to the extent necessary to determine whether there a ‘permanent establishment’ exists and to determine a proper attribution of income thereto.

VAT Obligations

The Circular also addresses the obligation to charge VAT, which currently stands at a rate of 18 percent. A foreign corporation which maintains substantial business activity in Israel via the internet, shall be required to register for Value Added Tax and its transactions with its Israeli market shall be liable to Value Added Tax. Thus, for example, a foreign website operator which provides advertising services or brokerage involving clients in Israel, or users in Israel, will be required to register as an entrepreneur for VAT purposes and should charge VAT on its services.

A foreign company operating a website for booking cars or hotels to Israeli consumers would be required to register as a “dealer” for VAT purposes and charge VAT on its transactions with Israeli residents. This raises many questions, as at the end of the day the service of the car rental or the hotel stay is not provided in Israel and not subject to VAT in Israel. In the case of the operation of a search engine by a foreign company, the company must register for VAT in respect of the income generated from Israeli clients.

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. This, within an OECD context, has not yet been decided.

The Circular does not have the standing of legislation and is, to a degree, in contrast with modern accepted international taxation principles and even in contrast with the already quite progressive anti-tax planning recommendations by OECD of the BEPS project.

These developments are very significant, raise many questions/uncertainty and will trigger additional regulatory (administrative & tax) requirements to most foreign providers of a digital service or good in(-to) Israel.