International taxation - Business investments – insight from taxation decisions on the subject of permanent establishment for foreign investors

Many entrepreneurs wish to direct their available capital to investment in Israeli companies in a variety of areas, in particular – the Israeli high-tech sector, known to be one of the central growth engines of the economy. Government grants and the enactment of the “Angels Law” and its recent amendment are just two examples of a wide variety of government incentives for those investments.

These investors are (generally) not novices who blindly invest their money without prior scrutiny; they typically engage advisors to identify potential deals, examine the financial feasibility of the company under consideration, perform due diligence and determine the best means of investment. Sometimes decisions to move forward with the investment are made by the advisors in cooperation with the investor (including in “investment committees”). Further on, investors may appoint such an advisor as their representative to the Board of Directors of the company in which they are investing, because such investors wish to be actively involved in guiding the company’s strategic business decisions in order to increase its profits. These are typical activities of all rational strategic investors of a particular company, who tend to hold on to those investments for quite a number of years.

An interesting taxation decision (tax ruling) published recently by the Israeli Tax Authority, stipulates that such a circle of advisors may classify the profits in a future sale of the shareholdings – as taxable profits from a business, rather than exempt capital gains! This taxation decision applies to investments in Israel by a foreign company which uses the services of a local management and advisory team. It stipulates that the investments of the foreign company in Israel and its accompanying activities establish a permanent establishment in Israel (which requires corporate tax or marginal tax rates, whichever appropriate, on its income). The method of allocation of taxable income of the permanent establishment is determined by costs (worker salary and service providers, general and administrative, et al) as per the ratio of their disbursement abroad versus locally in Israel (“the allocation mechanism”).

In certain cases the position at the basis of this taxation decision may in fact be advantageous for the taxpayer – as interest and dividends are obtained by the investors from their investment, these too are to be classified as a part of the business income of the permanent establishment and are thus also subject to the allocation mechanism. Thus, if the cost ratio indicates 90% abroad, for example, then only 10% of the interest and dividends obtained would be taxable in Israel. Nonetheless, the taxation decision agreed upon between the sides stipulates that all interest and dividend income is taxable in Israel; however from our stance it follows that this understanding contradicts the basis for the taxation decision – that is, the allocation of income to a permanent establishment in Israel (by the way, standard tax treaties also stipulate that taxation clauses that apply to interest and dividends shall not apply to income of a permanent establishment, as in that case the clause of business profits would apply, including implementation of the allocation mechanism).

The Tax Authority has been grappling with this issue of characterizing the class of income by investment funds – both small and large – for many years, and in practice, “qualified” investment funds have been granted benefits in the form of full exemption for cash-out and low rates on interest and dividends, both for venture capital funds and for private equity funds. For funds without a broad distribution of investors (with the limit generally set at 10 investors), and in this case – a single investor, it is indicated in the taxation decision that this approach is in lieu of a low tax rate track (in general between 10 and 15 percent). We maintain that in these cases, Israeli law is to be interpreted in its most liberal sense, with income from cashing out of investments by small funds, foreign investors and Israeli entrepreneurs to be classified as capital gains and not as business profits. Such an interpretation would encourage more investment in Israeli start-ups and would align with corresponding government goals (or at least would not hinder the volume of investment), would deem determination of relative costs unnecessary (after all, the tax assessor’s ability to inquire and control expenses abroad and their correspondence to Israeli investments is limited), and would allow full taxation of interest and dividends (subordinate to the provisions of the tax treaty), without the need to invoke the allocation mechanism described above.

For the sake of comparison, note that according to the Tax Authority’s policy regarding foreign hedge funds, which
execute hundreds and thousands of buy and sell securities transactions annually, income from those sales is classified as exempt capital gains.