Reproduced with permission from BNAI European TaxService Monthly Digest, 18 ets 09, 09/30/2016. Copyright �2016 by The Bureau of National Affairs, Inc.(800-372-1033) http://www.bna.com

SEPTEMBER 2016

INSIGHT

Israel’s Take on BEPSAction 1: Taxing theDigital Economy

Daniel Paserman and Danielle SkaldGornitzky & Co, Tel Aviv

In April 2016, the Israeli Tax Authority published a tax circular(the ‘‘Circular’’) addressing the taxation of foreign entities thatoperate in Israel via the internet. The following article considersthe Circular’s tax treatment of foreign entities, operating in Israelvia the internet.

I. Digital Economy

In recent years, there has been a substantialworldwide growth in the digital economy. The in-ternet has largely become an international key

platform for commerce and service delivery. The saleof products and the provision of services are done re-motely (online or through remote servers and ‘‘clouds’’located elsewhere), without an actual physical pres-ence in the country in which the consumer is located.

The digital economy raises fascinating and complexchallenges with regard to tax collection. The classicmodels of taxation and internationally accepted taxprinciples, such as territorial or personal tax regimes

or the permanent establishment concept providedunder tax treaties, may turn out to be irrelevant in theera of digital economy. In many cases, tax laws and taxtreaties were formulated decades ago, prior to thetechnological revolution, a time when policymakerscould not have envisioned that one day trade and ser-vices will become virtual. These gaps between thepresent-day economy and existing legislation createmany tax distortions including disproportionately lowtax collections in countries with high consumption ofproducts and services.

In October 2015 the Organisation for Economic Co-operation and Development (‘‘OECD’’) released the

Adv. (CPA) DanielPaserman is aPartner and Headof Tax at Gornitzky& Co and Adv.(CPA) DanielleSkald is an Asso-ciate at Gornitzky& Co .

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Base Erosion and Profit Shifting Project (‘‘BEPS’’)Report (‘‘the Report’’), which deals, among otherissues, with the challenges derived by the digitaleconomy. The purpose of the Report was to deal withthese challenges, inter alia, by coordinating betweencountries and implementing global norms.

II. The Israeli Tax Authority’s Circular

In April 2016, the Israeli Tax Authority (‘‘ITA’’) pub-lished a tax circular (‘‘the Circular’’); addressing thetaxation of foreign entities that operate in Israel viathe internet and providing guidelines to the assessingofficers. The ITA did not initiate a comprehensivechange in legislation; instead it issued this tax circu-lar, solely dealing with actions performed over the in-ternet. Professional circulars that are published by theITA are nonbinding towards taxpayers, yet they serveas a ‘‘safe harbor’’ for those that act according to therelevant recommendations of the circular. In any caseit is foreseen that the publication of the Circular willcause the ITA to be more active vis-a-vis foreign enti-ties with business activity in Israel carried out via theinternet.

The Circular opens by acknowledging the changestaking place in the global economy and the expansionof business activity via the internet. It emphasizes thattoday more foreign entities sell products and provideservices to Israeli clients over the internet either di-rectly or with the assistance of affiliated Israeli com-panies, representatives or subcontractors, who areengaged in marking of the business or its technicalsupport.

The guidelines provided in the Circular distinguishbetween foreign entities residing in a country that hasa tax treaty with Israel (‘‘Treaty Country’’) and entitiesresiding in a country that does not have a tax treatywith Israel (‘‘Non-Treaty Country’’). The Circular alsoimposes reporting requirements on online businessesoperating in Israel and briefly deals with certain VATmatters. The following briefly describes the mainissues presented in the Circular.

III. When are Foreign Entities Subject to IsraeliTax?

In general, according to Israeli tax law, businessincome of a foreign entity is subject to tax in Israelonly if the income is generated in Israel. The IsraeliTax Ordinance (‘‘ITO’’) provides that income is consid-ered to be produced or generated in Israel only if thebusiness activity itself is carried out in Israel. How-ever, Israeli tax would be levied if the relevant foreignentity is a resident of a Treaty Country only if it has apermanent establishment (‘‘PE’’) in Israel. The OECDModel Tax Convention, which is the basis for most ofthe recent tax treaties to which Israel is party, providesthat a PE may arise under two circumstances: (i) thebusiness activity is conducted through a fixed place ofbusiness at the disposal of the foreign entity; or (ii) thebusiness activity is conducted through a dependentagent that has the authority to, and habitually con-cludes, contracts on behalf of the foreign entity.

When dealing with online transactions, Israelicommon practice has been that a fixed place of busi-ness is determined according to the location of the

servers. However, according to the Circular, existingpractice does not coincide with the Report’s recom-mendations and does not correlate with today’seconomy. Today, many foreign entities conduct theirbusiness and approach Israeli customers via a websitedesigned in Hebrew; however, they choose to locatethe server outside of Israel. In view of this, accordingto the Circular, when determining the existence of aPE, less importance should be attributed to the loca-tion of the server; in this era of digital economy theserver may be located anywhere in the world whilstthe various marketing, support and development ac-tivities may be located elsewhere. These changes re-quire modification of the current rules.

IV. Business Activity in Israel of a Foreign TaxResident Entity from a Treaty Country

A. Alternative I—Fixed Place of Business of the ForeignEntity

The foreign entity may perform its online business ac-tivities through a fixed place of business in Israel.When the foreign entity has a branch, an office or anyother facility in Israel used by the foreign entity toconduct its business, this can be treated as a PE inIsrael. Additionally, the Circular determined thatwhen the representatives and employees of the foreignentity make use of an Israeli office of a related partythat is considered an Israeli tax resident, the ITA mayregard it as a PE of the foreign entity.

It is important to note that the OECD Model Con-vention provides some exceptions; in general, an ac-tivity of a preparatory and auxiliary nature does notconstitute a PE. Such activity may include the use offacilities for storage of goods, exhibitions, delivery oruse of facilities for the purpose of collecting informa-tion or purchase of goods.

The Circular notes that the unique feature of busi-ness activity conducted via the internet may establisha PE, emphasizing that if, in addition to the prepara-tory and auxiliary activity performed in the facility,another business activity of the foreign entity takesplace, such facility shall be treated as a fixed place ofbusiness, and thus constitute a PE for all the activitiesof the foreign entity. According to the Circular the fol-lowing activities which take place alongside the pre-paratory and auxiliary activity of the foreign entitymay be treated as constituting a PE for the foreignentity: (i) identifying potential clients and marketingactivities; (ii) management of the relationship withthe Israeli customer including organizing confer-ences, exhibiting new products, gathering informa-tion on the Israeli market and so on.

The above was already an existing practice for themost part, but the Circular introduced a new aspect inproviding that, what was treated in the past as a pre-paratory and auxiliary activity only may, in the digitalera, be treated as a business activity which constitutesa PE for a foreign entity if the foreign entity has a sig-nificant digital presence in Israel. The Circular pro-vides some criteria for such significant digitalpresence:

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(i) a significant number of contracts for providingdigital services was signed with Israeli residentsover the internet,

(ii) a significant number of customers in Israel usesthe foreign entity’s services via the internet, or

(iii) the online service is tailored to Israeli customers,i.e., the charge for the services is in local currencyor the service provider is able to clear Israelicredit cards and so forth.

B. Alternative II—Dependent Agent

Another alternative as to when a foreign entity mightbe deemed to have a PE according to the OECD ModelTax Convention is when a foreign entity has a depen-dent agent in the other country, i.e. a person that hasthe authority to bind the foreign entity in contractsand habitually exercises such authority. The Circularprovides that even when a dependent agent does notsign the contract itself but performs all the requiredactivities for the foreign entity to sign the contract,such person might be treated as a dependent agentand as such constitute a PE for the foreign entity.

The Circular provides a list of situations whereby anIsraeli agent acting on behalf of the foreign entity maylead to a PE of the foreign entity in Israel. These in-clude the following: (i) lack of involvement on the for-eign entity’s part; (ii) orders placed by the Israeli agentare routinely approved by the foreign entity; (iii) theIsraeli agent has the authority to set the commercialterms and the price; (iv) there is significant involve-ment of the Israeli agent in the adjustment of the con-tract to the needs and requirements of the Israelicustomer; or (v) the Israeli agent is a party to a con-tract between the foreign entity and the Israeli client.

V. Business Activity in Israel of a Foreign TaxResident Entity from a Non-Treaty Country

When the foreign entity is a resident of a Non-TreatyCountry, it is subject to tax in Israel if the business ac-tivity is carried out in Israel. The Circular providesthat with respect to digital economy, a business activ-ity is carried out in Israel if (i) the business activity iscarried out via a fixed place of business, (ii) if the busi-ness activity is carried out via the assistance of anagent in Israel, or (iii) if there is a significant economicpresence of the foreign entity in Israel. The Circular es-tablishes once again that if the online activity is alsosupported by the existence of a physical location or arepresentation in Israel, including a related entity orbranch, such an activity should be considered as onecarried out in Israel.

As to the first alternative, the Circular provides thatwhen the foreign entity has a physical presence inIsrael, the foreign entity shall be treated as having aPE in Israel. Physical presence includes, inter alia, of-fices or facilities for preparatory or auxiliary activitiesof the foreign entity as well as engaging employees orhaving a facility where it provides services for the Is-raeli customer or has a branch in Israel.

As to the second alternative, the Circular provides alist of events in which the activity of a local agent in-cluding an Israeli-related entity might be treated as abusiness activity, carried out in Israel, of the foreignentity with a business activity via the internet: (i)

when representatives of the foreign entity are involvedin lead generation or in gathering information or as-sistance through a representative in Israel, or (ii) ifthere are ongoing activities between the representa-tives of the foreign entity and the Israeli customers interms of customer relations, such as the organizationof conferences for customers, creating opportunitiesto display products, development and improvement ofthe service provided to the customers, provision offeedback with respect to the activities of a foreignentity in the domestic market and so on, and (iii) if theservices provided including marketing, billing, sup-port, consulting are partially or fully provided by anIsraeli agent.

The third alternative, introduced by the ITA, is aninnovation of the ITA in determining what shall betreated as business activities of the foreign entities inIsrael and provides that even if the foreign entity doesnot have a physical presence in Israel, it does, how-ever, have a significant economic presence in Israel,and thus such activity shall be treated according to theCircular as business activity carried out in Israel. Inthis regard the Circular provides a list of criteria ofwhen an activity is to be deemed as having a signifi-cant economic presence:(i) the foreign entity provides internet services to cus-

tomers, including advertising, brokerage, market-ing, support etc. with respect to Israeli clients,

(ii) the foreign entity has a significant number oftransactions with Israeli customers via the inter-net,

(iii) the foreign entity provides services to Israeli cus-tomers via the internet and the platform is tai-lored for Israeli clients (for example the website isin Hebrew, the website has local advertisements,the charge for the services is in local currencyetc.),

(iv) the services provided by the foreign entity are con-sumed by many Israeli customers via the internetand

(v) there is a strong connection between the remu-neration paid to the foreign entity and the extent ofuse by Israeli customers.

VI. Attribution of Income

A. Foreign Tax Resident Entity from a Treaty Country

If a foreign entity from a Treaty Country is deemed tohave a PE in Israel, its income and profits shall be at-tributed to said activity. The Circular provides that at-tribution of income to a PE shall be done according tothe Authorized OECD Approach (‘‘AOA’’) that was pre-sented in the 2010 OECD report on the attribution ofprofits, and is based on the arm’s length principle.Hence, the functions, assets and risks of the activity inIsrael should be analyzed.

B. Foreign Tax Resident Entity from a Non-Treaty Country

However, when the foreign enterprise is from a Non-Treaty country, the Circular provides little guidanceregarding the attribution of profits, saying only thatthe attribution shall be based on the examination ofthe functions, assets and risk of the activity carried

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out in Israel (‘‘FAR’’) without referring to any specificattribution approach.

VI. Reporting Requirements

The Circular imposes reporting requirements on for-eign entities which are treated as having a PE in Israelor in cases of foreign entities from a Non-Treaty Coun-try who have a business activity in Israel in respect ofprofits attributed to the PE or to such activity in Israel.

Moreover, according to the Circular, in order to ex-amine whether the foreign entity has a PE or a busi-ness activity in Israel the ITA has unlimited authorityto require any information and documentation fromthe foreign entity and its affiliates, regarding their ac-tivity in Israel. In this regard, it should be noted that itis questionable whether the ITA has indeed suchbroad authority.

VIII. Value Added Tax

The Circular also refers to Value Added Tax (‘‘VAT’’)implications on foreign entities providing services viathe internet to Israeli customers.

According to Israeli VAT law, a service is to betreated as a ‘‘deal’’ in Israel if it meets one of the fol-lowing requirements: (i) the services are provided by aperson who conducts business activity in Israel, (ii)the services are provided to Israeli customers or (iii)the services are provided with respect to an Israeliasset. According to Israeli VAT law, if the service isprovided by a foreign resident, in general the liabilityto pay the VAT lies on the person who receives the ser-vices, i.e. the Israeli customer (unless the person pro-viding the services is a ‘‘dealer’’ for VAT purposes).However if the foreign service provider has a businessactivity in Israel, it is required by the VAT law to regis-ter in Israel as a ‘‘dealer’’ for VAT purposes and report(including issuing of an invoice) and pay the VAT onsuch deals. Moreover, such a service provider, who isregarded as an Israeli ‘‘dealer’’ must appoint a localrepresentative in Israel.

In this regard, the Circular provides criteria accord-ing to which the foreign entity providing services to Is-raeli customers shall be considered an entityconducting business activity in Israel and as such isrequired to register as a ‘‘dealer’’ and pay the VAT inIsrael: (i) the activity of the foreign entity constitutes aPE for income tax purposes in Israel, (ii) the foreignentity has a business mechanism in Israel; a branchemployees, offices or any other physical existencethrough which it conducts its business activity, (iii)the foreign entity conducts business in Israel with theassistance or collaboration of an Israeli agent, or (iv)

the foreign entity has a significant economic presencein Israel. The Circular provides under which circum-stances the foreign entity shall be treated as having asignificant economic presence in Israel, and as suchshall be required to register as a ‘‘dealer’’: if the foreignentity (i) provides services to Israeli customers via theinternet which include advertising, brokerage, mar-keting, support and etc., (ii) has a significant numberof transactions with Israeli customers via the internet,(iii) provides services via the internet to Israeli cus-tomers and the platform is tailored for Israeli clients,(iv) the services provided via the internet by the for-eign entity are used by many Israelis and (v) there is astrong connection between the remuneration paid tothe foreign entity and the extent of use by the Israelicustomers.

In addition to the Circular, it should be mentionedthat in March 2016 (a few days before the publicationof the Circular), the Israeli Ministry of Finance pub-lished a draft bill to amend the VAT law according tosimilar concepts that were also presented in the Circu-lar. If the bill is passed, it will require nonresident sup-pliers of digital services to register and account forVAT in Israel, as suggested in the Circular.

IX. Conclusion

It seems that the ITA is attempting to be a world pio-neer in drafting domestic guidelines for implementingthe BEPS recommendations and address the tax chal-lenges brought about by the digital economy. There isno doubt that a major change has been set in motionfor the foreign entities operating via the internet andtherefore these entities should make proper arrange-ments.

It should be noted that following the publication ofthe Circular, the ITA is already implementing theguidelines of the Circular with respect to the activityof foreign digital technology companies in Israel. Notonly that, the ITA has implementing the guidelines ofthe Circular even beyond the spectrum of the Circular;including implementation of the guidelines on all typeof foreign entities, even those entities that are not op-erating in Israel via the internet.

Adv. (CPA) Daniel Paserman is a Partner and Head of Tax atGornitzky & Co and Adv. (CPA) Danielle Skald is an Associate at

Gornitzky & Co . They can be contacted at:

Paserman@Gornitzky.com; anddaniels@Gornitzky.com

http://www.gornitzky.com

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