A question that often arises when considering a legal entity for international business operations is whether to set up a subsidiary in a foreign country or a branch office (i.e. permanent establishment); that is, direct company operation in the target country. This question also arises among foreign clients wishing to operate in Israel.
As with any tax-related issue, there is no single right answer; the specific circumstances must be considered on a case-by-case basis. We will attempt to address the main differences that could aid our readers in considering their own particular preferences:
Corporate tax rate: In general, a company’s activity in a foreign country is subject to local corporate tax on its profits, regardless of whether it is a company or a branch office. A foreign subsidiary of an Israeli company pays its corporate taxes in its country of residence. A foreign company operating in Israel via a branch office pays Israeli corporate tax (23%) on the profits attributed to that branch.
For a branch office, keep in mind that revenues derived outside the country of residence of the branch are generally not subject to taxes within that country. On the other hand, revenue of a subsidiary derived outside the country of residence are subject to tax by the subsidiary, since the taxation method is for the most part worldwide and not territorial, with certain exceptions (for example, the existence of participation exemption regimes).
There are additional considerations; for example, activity eligible for benefits by virtue of Israeli encouragement laws would require operation via an Israeli subsidiary (by the provisions of the encouragement law).
Tax rate on distributions: In addition to corporate taxes that would apply to a branch office or a subsidiary, distributional taxes need to be considered as well – whether on dividends distributed by a subsidiary, or distributions from the branch office to the parent company. In the US, for example, a branch tax is imposed on the branch’s profits, equivalent more or less to the amounts that would have been distributed as dividends had it been a subsidiary. The tax rate that applies to the profits eligible for distribution of an American branch office is 12.5%, as per the provisions of the treaty with Israel. This rate also applies to dividend payout from an American subsidiary to its Israeli parent company. On the other hand, profit sharing from an Israeli branch office of a foreign company does not require additional taxes since Israel has no branch tax. Dividends from an Israeli subsidiary to its foreign parent company are taxable in Israeli in accordance with provisions of the internal law (30%) or at a reduced rate as per the provisions of Israeli encouragement laws or relevant treaty provisions.
Offset of losses: According to Israeli law, foreign subsidiary losses may not be offset against parent company revenues, unless explicit provisions indicate such; an example of this could be a transparency regime for tax purposes that applies to the subsidiary (in relation to determining taxable revenues of the parent company). Losses associated with a branch office in a foreign country, under the conditions indicated in the Ordinance, may be offset against the company’s revenues.
Foreign tax credit: In Israel, in general, keep in mind the foreign taxes paid by a branch office in a foreign country or by a foreign subsidiary, including taxes withheld from their dividend payouts. We will demonstrate this with an example of an Israeli company and an American company:
Credit in Israel: In the case of a subsidiary, foreign tax in Israel would be credited only at the time of dividend payout and not on a regular basis; furthermore, excess credit may not be carried forward to subsequent years (in accordance with the Israeli principles of “underlying tax credit”). In the case of an American subsidiary that paid, for example, 28% (federal and state) tax and pays out a dividend from which 12.5% was withheld, with total foreign tax (direct and indirect) at an effective rate of 37%, the Israeli company would not be required to pay additional taxes at the time of dividend payout, due to the credit granted, although the excess credit of 14% would not be carried forward to the following years.Had it been a branch office, then the American corporate taxes paid by the branch office as well as branch taxes, also with an effective tax rate of 37%, would be granted (in our opinion) full credit from Israeli corporate tax, and the 14% excess could be used as an offset against taxes owed for other foreign-sourced revenues (on condition that they are in the same income basket).
US credit: In the other direction, an Israeli subsidiary paying out dividends to an American company would pay a total effective tax rate of 33% (corporate tax and dividend tax). This tax cannot be fully exploited by the American company because of the new tax regime (in effect from 2018) which grants a waiver to American companies for foreign-sourced dividends. In this sense it would be preferable for an American company to operate in Israel via a branch office, since in such a case only corporate taxes would be required – 23% (which would be credited from the American tax). There are, of course, additional reasons for choosing this option over the alternatives presented above, including considerations of limiting responsibility and/or protection of intellectual property.
In any event, before beginning operations, consider the proper legal entity, taking into account the type of activity and the countries in question.