On April 21, 2015, we published in this website a review of the draft circular published at the time by the Israeli Tax Authority ("ITA"), containing guidelines with respect to the income tax and VAT aspects applicable to foreign enterprises that transact with Israeli customers over the internet ("the Circular" and "Foreign Enterprises", respectively).

Almost a year has passed since the publishing of the circular, and it now appears that the ITA has been quietly working behind the scenes in order to promote new legalization which will equip it with the required authority and tools to enforce the taxation of Foreign Enterprises' digital activities in Israel. Recently, on March 13, 2016, the Ministry of Finance published a draft bill for the amendment of the VAT law ("the Draft Bill"), according to which new provisions will be added to the VAT law to enable imposing VAT and reporting liabilities on Foreign Enterprises' activities in Israel.

The position of the tax authorities is that under the current legal situation in Israel, the VAT that is liable on services or merchandise provided via the internet by Foreign Enterprises, that are not registered in Israel, to Israeli residents ("the Digital Services") should be paid by the Israeli buyer or the services receiver. In practice, the enforcement of the collection of VAT from private buyers that are not dealers is almost impossible and, as a result, the VAT is never paid to the ITA. It should be noted that, according to the Base Erosion and Profit Shifting (BEPS) recommendations, this problem is common in a large number of countries around the world, and it should be treated domestically by the each of the OECD members, in order to prevent double-taxation or non-taxation of income. 

The Draft Bill wishes to address the situation described above by obliging the Foreign Enterprises to collect and pay the VAT liable on the Digital Services provided by them. According to the Draft Bill, Digital Services include "electronic products and services", "communication services" and TV and radio broadcasting. These terms are broadly interpreted in the Draft Bill, and they include a wide spectrum of services and products, such as: computer software, entertainment products, books, music, games, TV shows, movies, telecommunication and facsimilia services, internet services…etc.

According to the provisions of the Draft Bill, the Foreign Enterprises will be required to pay the VAT liable on the Digital Services provided to Israeli residents. However, in the event that the Digital Services are provided to an Israeli resident which is a dealer, NPO or financial institution, which are all registered with the VAT authorities, the service receiver will be required to pay the VAT. In both ways, the VAT liability is expected to cause higher costs for the Israeli purchaser. In addition the Draft Bill proposes that an Israeli dealer, which provides taxable services to Israeli residents, will be required to pay the VAT, even in the event that the services are provided abroad.

Furthermore, the Draft Bill proposes imposing registration and reporting liabilities in Israel on Foreign Enterprises that provide Digital Services or operate online stores through which Digital Services are provided. For this purpose, the Draft bill determines the establishment of a new unique registry for foreign enterprises that is separate from the regular dealers' registry. In addition, the tax manager will be entitled to assess the Foreign Enterprises' reporting and require further payments, should they be applicable.

In light of the aforementioned, it is clear that, following the enactment of the Draft Bill, the tax and business reality concerning the sector of digital services and merchandise internet trade will not be the same. The Foreign Enterprises will be required to make the necessary adjustments in order to comply with the new Israeli VAT obligations.

As for the income taxation of the Foreign Enterprises' Digital Services in Israel, it should be noted that, although the circular describes a highly aggressive approach of the ITA concerning imposing income taxes on the said Digital Services, by arguing that the digital activities in Israel establish a permanent establishment ("PE") in Israel, neither the ITA nor the lawmakers have yet to publish any bills or instructions to promote the implementation of such provisions. It is our opinion that the aforesaid broad interpretation of the term PE is remote and inconsistent with the position of the OECD as it is reflected in the commentary of the OECD convention model, according to which most of the Israel tax treaties are based.  In addition the fact that the Israeli tax ordinance clearly stated that the provisions of the said tax treaties prevail over the domestic tax law, make it very challenging for the Israeli legislators to enact new domestic provisions that contradict with the provisions of the different tax treaties, by imposing taxes on Foreign Enterprises that do not maintain a PE in Israel.