In April 2016, the Israel Tax Authority (“ITA”) published a circular (No. 4/2016) dealing with the taxation of foreign corporations due to activity conducted on the Internet and targeting Israeli customers. Without going into excessive detail, we should point out that this is a significant change in all matters relating to source rules of income and interpretation of the existence of a permanent establishment according to the tax treaties which Israel has signed.

Recently we became aware of various publications relating to the intent of the ITA, quite justifiably, to tax foreign corporations (such as Google and Facebook) providing services to Israeli residents. However, the ITA’s intent focused primarily on VAT liability concerning those transactions. As a background, we should point out that the VAT law in Israel imposes VAT on a foreign resident providing services to an Israeli customer’ regardless the transaction situs. However, due to the unenforceability of imposing VAT on Internet based transactions, it has become necessary to form rules on the subject, including registration of such foreign residents as service providers in Israel, and accordingly, on March 13, 2016, a memorandum for amending the VAT law on the subject of charging service providers in the digital and Internet field VAT was published.

In a circular that has just been published, the ITA is trying to implement the law applying to VAT taxation in the context of corporate tax and income tax too. In other words, if the transaction is subject to VAT, then why should it not be subject to corporate/income tax? To this day, traditionally, as expressed in legislative acts, the professional interpretation of the ITA and the interpretation of the OECD treaty model, the place of where the income from services was generated has been determined as the place where the services were provided! For example, if a resident of Israel consumes a legal service from a foreign attorney (such as giving a legal opinion), which is given by that foreign attorney from abroad, the foreign attorney is not subject to income tax because it was not generated in Israel, even if the said service is liable for VAT (apart from the question of who must actually pay the VAT). In the circular that has just been published, the ITA is “updating” its worldview concerning the place where the income from internet-based services are generated, by establishing a concept of “significant economic presence”, i.e., “virtual” presence in a place in which there are Israeli customers or in which the service provided or the product sold has Israeli contexts – even without any physical presence in Israel! By doing so, the ITA is aligning the concept of taxation and the transaction place to the existing VAT law. However, because the circular relates only to digital transactions, there is variance between transactions that are performed using a digital platform, on which the new approach is based, for which the supplier of the product or provider of the service will be subject to tax, and transactions that are performed through other means, for example by telephone transaction, in which case the supplier of the product/provider of the service will not be subject to tax. In our opinion, there is a lack of a legal basis to distinguish between the two different platforms, meaning that the legislation must be updated in this regard. In the case of a corporation residing in a treaty country, the principle of the permanent establishment requirement is maintained, but the ITA states that certain activities that were considered to this day as activities of a preparatory or auxiliary character are considered in the modern digital era as significant activities that may constitute a permanent establishment (finding customers, customer relation management, etc.). However, at the stage of attribution of incomes to that permanent establishment, the ITA states that the “significant people functions” approach must be implemented and the presence and contribution of the key people operating the permanent establishment must be identified.

We are of the opinion that prior to the discussion whether a permanent establishment exists (followed by attribution of incomes to it), Israeli domestic law and the question of whether there is business activity / provision of service occurring in Israel should be discussed. To the extent that it is determined that there is no activity that is being held geographically in Israel, then there is no taxation right in Israel, even if the definition of a permanent establishment is changed in the OECD treaty model commentaries– following the BEPS project report dealing with such aspects of the digital economy. In the last case, to the extent that Israel asks to implement the said interpretation, this should be done by a legislative amendment, particularly when there is variance between services / products provided to Israeli customers using digital means and such services and products provided in other ways. Also, the ITA should be aware that the new approach set forth above may be implemented the other way round: an Israeli entrepreneur may set up an enterprise through a foreign company that is run by a team of employees in Israel and that is based on Web activity, platform and infrastructure, for customers outside of Israel only – and argue that the Company has an “economic presence” outside of Israel meaning that the income of the enterprise is not taxable in Israel.