This is an important update for any online foreign company that provides services or sells goods to Israeli customers.

  1. Background
    1. Yesterday, the Israel Tax Authority (the "ITA") published a circular (the "Circular") addressing Israeli taxation of non-Israeli Internet companies (a "company" or "companies"). The Circular covers the corporate income tax liability of companies selling goods or providing services to the Israeli market through the Internet as well as the value added tax ("VAT") liability of Internet services companies.
    2. The Circular is a final version of a draft circular that was released a year ago to a number of industry participants and professionals to receive feedback. The Circular  is  released  in parallel to a memorandum of proposed draft legislation addressing the issue of VAT applicable to companies in B2C transactions which was just published.1 The publication of the Circular comes at a time of widespread public criticism regarding the taxation of companies operating in Israel. The Circular takes somewhat extreme positions that practically speaking, may subject almost every company active in the Israeli market to corporate income tax and VAT.
    3. It should be emphasized that the Circular represents the ITA's interpretation of the law and accordingly, its position on said matters. The Circular does not, however, have any legal binding status and therefore, courts are not bound by it.
    4. The Circular also applies to previous tax years; there is no future date for implementation of the Circular given the ITA's position that it constitutes interpretation of the law.
  1. Corporate Income Tax Aspects
    1. Regarding companies resident in treaty jurisdiction countries (that is, countries that are party to a tax treaty with Israel), the Circular provides new interpretations to the definitions of permanent establishment (a "PE") through a "fixed place of business" and a "dependent agent" contained in such tax treaties in the context of digital economy.
    2. Fixed Place of Business PE.
      • The  Circular marginalizes  the  importance  of  the server's  location  as  a  factor  in determining the existence of a PE. The Circular states that a PE may exist even where there is no Internet server located in Israel.
      • The Circular notes that certain activities of representatives of a company in Israel such as identifying potential clients, marketing activities and client relationship management, when conducted with assistance from, or through, a place of business in Israel, may create a PE.  Examples of client relationship  management include organizing conferences, creating opportunities for the introduction of new products, and providing feedback on the operation of a company in the local market. The Circular points out that a company with "significant digital presence in Israel" may be treated as creating a PE in Israel if there is some place of business in Israel that would otherwise been considered as preparatory and auxiliary. Based on the Circular, indications of the existence of a digital presence in Israel include a significant number of contracts signed with Israeli residents via the Internet, a significant number of customers in Israel consume the services provided by such company, and the services over the Internet have been adapted to suit Israeli customers such as a website in Hebrew, using local currency and local credit card clearance.
    3. Dependent Agent PE. With  respect to creating  a PE through  a "dependent agent", the Circular adopts an approach pursuant to which increased involvement of the agent in Israel in negotiations on behalf of, and in decisions that bind, a company, reinforce the conclusion that the dependent agent will be treated as a PE of the company. The Circular notes the following as indicative of a PE of such company in Israel:
  • Lack of involvement of the company in the transaction;
  • Customer  orders  made  by  the  agent  in  Israel  are  routinely  approved  by  the company;
  • The agent in Israel is authorized to fix a price or other commercial terms which bind the company;
  • Significant  involvement  of  the  agent  in  Israel  in  tailoring  the  terms  of  an agreement to meet the needs and requirements of Israeli clients;
  • The  agent  in  Israel  is  party  to  the  contract  between  the  company  and  the customer.
  1. Non-Treaty Country Companies' Tax Threshold. For companies resident in non-treaty jurisdictions, the Circular notes that Israel's right to tax will be determined based solely on domestic Israeli law, which generally provides such right to tax income generated from business activities conducted in Israel. This standard for taxation under domestic law is lower than the PE threshold. Based on the Circular, the following are indicative of business activities conducted in Israel:
  • Representatives of the company involved in identifying customers and collection of information, or an ongoing relationship between such representatives and Israeli customers, in each case, with assistance from, or through, a representative in Israel.
  • The  provision  of  marketing,  billing,  support,  consulting,  customer  or  other services, all or part of which are provided in Israel through a representative in Israel.
  • The existence of "significant digital presence" in Israel even without a physical presence in Israel.
  1. Attribution of Profits to Israel.
    • For treaty country companies, the Circular adopts the so-called Authorized OECD Approach, which essentially views the PE as a separate legal entity and examines what profit such 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, which analysis generally aims to establish which of the company’s assets, risks and other functions should be viewed as belonging to the PE. The second stage involves the transfer pricing under the framework of treating the PE as a stand-alone business.
    • For non-treaty country companies, the Circular indicates very generally that an asset and risk functions analysis should be performed in order to determine the profits attributable to Israel.
  2. Authority to Obtain Information from Companies - the Circular indicates the ITA position pursuant to which it has the power to demand information from non-Israeli companies regarding activities carried out in Israel for the purpose of determining the existence of a PE and allocation of profits to such PE. Examples of such information include functions performed in Israel, turnover, income, and expenses with respect to the various Israeli activities.
  1. VAT Aspects
    1. The Circular details the ITA's position regarding when a company engaged in the provision of services via the Internet to customers in Israel is viewed as conducting a "business in Israel" and is thus obliged to register with, and pay VAT to, the VAT authorities. Currently, the Israeli VAT rate is 17%.
    2. The Circular specifies that when a PE exists for corporate income tax purposes, a corresponding VAT registration and tax liability obligations arises.
    3. In addition, the Circular applies unprecedented broad interpretation with respect to the VAT registration obligation. For example, certain activities of a representative of the company in Israel, such as identifying potential clients, marketing activities and client relationship management activities, will trigger the VAT registration obligation. The Circular also notes that companies with significant economic presence in Israel may also be subject to VAT registration obligation.
    4. This approach in relation to the VAT registration obligation is inconsistent with the memorandum of proposed draft legislation which was just published, and which applies a separate registration framework for companies and a special reporting regime. The proposed legislation requires only companies that perform B2C transactions with Israeli residents to register for VAT purposes. The Circular does not mention the proposed legislation nor does it specify the relationship between the proposed legislation and the Circular.
    5. The Circular states that companies that are subject to the VAT registration obligation in Israel will not be considered as "foreign residents" for purposes of the zero-rate VAT. Such determination is relevant to many companies that receive development and marketing services from Israeli companies which currently do not charge VAT for such services.