On April 11, 2016, the Israeli Tax Authority ("ITA") published Circular Number 04/2016 which provides guidelines with respect to the income tax and VAT aspects applicable to foreign companies that transact with Israeli customers over the internet ("the Circular" and "Foreign Companies", respectively). The Circular was published almost a year after the publishing of its draft, which was reviewed by us on April 21, 2015. In this article, we will review the main points of the Circular.

Income Tax Aspects:

The Circular provides new and unprecedented guidelines and rules under which Foreign Companies' income derived from selling products or providing services through the internet to Israeli residents ("Digital Activity"), will be deemed the income of a permanent establishment ("PE") in Israel. The Circular distinguishes between Foreign Enterprises which are residents of a treaty state ("Treaty Resident Companies") and Foreign Enterprises that are residents of a non-treaty state ("Non-Treaty Resident Companies") and provides different rules for determining the attributed income to the Israeli PE for either of the aforementioned companies.

According to the ITA's approach that is reflected in the Circular, when examining the existence of an Israeli PE for Treaty Resident Companies conducting Digital Activity, special consideration should be taken. For example, greater significance should be placed on the economic business and financial activity conducted in Israel, even where the Foreign Company’s servers are located abroad. In addition, the Circular provides that activities that are usually considered of a preparatory or auxiliary nature, and as such belong to the exceptions of the definition of PE as set forth in Article 5 of the OECD Model Tax Convention, might establish a PE in Israel for Treaty Resident Companies that conduct Digital Activity with Israeli residents, should such Foreign Company conduct advertising and customer locating activities, customer relations management or have a significant digital presence in Israel. In this context, the Circular provides the following indicators for a significant digital presence in Israel:

  • Significant number of digital services contracts "signed" via the internet with Israeli residents.
  • Many Israeli residents use the digital services that are provided by the Treaty Resident Company via the internet.
  • The Treaty Resident Company provides digital services via the internet that are ideally suited for Israeli resident consumers. For example, operating a website in the Hebrew language or charging Israeli consumers in Israeli currency.

Without derogating from the aforementioned, the Circular provides that the Treaty Resident Companies may be considered as having a PE in Israel if their Digital Activity is conducted in Israel with the assistance of related Israeli companies or Israeli service providers ("Israeli Agent") that are dependent agents. The Circular provides indicators under which the Israeli Agent will be considered a dependent agent. These indicators reflect a more “trigger-happy” approach for recognizing a dependent agent. For example, the Israeli Agent is authorized to accept customers' orders that are routinely approved by the Treaty Resident Company or the Israeli Agent is authorized to guarantee the prices or the commercial conditions of the deals.

On the other hand, the Circular provides more aggressive guidelines for determining a place of business in Israel for Non-Treaty Resident Companies that conduct Digital Activity in Israel. It seems that the ITA's approach is that even insignificant preparatory or auxiliary activity conducted in Israel by the Non-Treaty Resident Company itself or with the assistance or collaboration with an Israeli Agent, may establish a place of business in Israel and, as a result, be subject to Israeli taxes.

Perhaps one of the most aggressive approaches in the Circular is considering Non-Treaty Resident Company, which does not have any physical existence in Israel, as a company that conducts a business activity in Israel, and such to be subject to Israeli taxes. According to the Circular, if a Treaty Resident Company has a significant economic presence in Israel, as a result of its Digital Activity, it will be considered to conduct business activity in Israel, even if does not have any physical existence in Israel. In this context, the Circular provides several indicators for a significant economic presence, such as a significant amount of transactions with Israeli customers, a significant number of Israeli consumers of the company's digital services, a significant number of Israeli users of the company's website, etc. We doubt if this approach will be adopted by the Israeli courts.

VAT Aspects:

In addition to the aforementioned, the Circular determines that a Foreign Company that provides services to Israeli residents via the internet, will be required to register as a "dealer" for VAT purposes and to report and pay the liable VAT (currently 17%) on such deals, if the company conducts business in Israel. The Circular provides the following criteria under which the Foreign Company will be considered a company that conducts business in Israel:

  • The activity of the Foreign Company establishes a PE in Israel; or
  • The Foreign Company has a business mechanism in Israel that includes a branch and/or employees and/or offices or other physical existence through which it conducts a preparatory or auxiliary activity.
  • The Foreign Company conducts business in Israel with the assistance or collaboration of an Israeli Agent.
  • The Foreign Company has a significant economic presence in Israel, as described above.

It should be noted that, at this stage, the correlation between the above registration requirement and the registration requirement set forth in the bill proposing amendments of the value added tax statute – 1975, which was reviewed by us in an article published on this site on March 17, 2016 ("the Bill"), is not clear. On the one hand, the Bill proposes a registration obligation on Foreign Companies that conduct transactions with Israeli residents, in a unique register for foreign companies and, on the other hand, the Circular stipulates a registration liability in the regular dealers' registry.     

In conclusion, it appears that the ITA is trying to turn Israel into one of the first countries to utilize domestic guidelines for implementing the Base Erosion and Profit Shifting (BEPS) recommendations for addressing the tax challenges of the digital economy, even before modifications of the OECD Tax Model Convention have been implemented. It will be very interesting to see whether the above-mentioned modifications will be as aggressive as the guidelines in the Circular. Furthermore, it will be very challenging for the ITA to justify its position if it is not consistent with respect to the above-mentioned modifications, especially if such modifications are not adopted by the rest of the treaty countries that have signed tax treaties with Israel.

In any event, we are at the opinion that the Circular does not seal the fate of the income earned via the internet by the Foreign Companies that conduct digital activity with Israeli residents. Foreign Companies that implement a correct and immediate modification of its business physical activity in Israel and of its relations with the Israeli business parties and/or Israeli related companies may eliminate or significantly reduce its exposure for Israeli taxes on its digital activities.