Monday, 25 July 2016

Israeli tax authorities clarify PE/VAT issues for foreign digital suppliers

On 11 April 2016, the Israeli tax authorities (ITA) published the final version of a circular concerning the digital economy, which previously was released in draft form in April 2015. The circular clarifies the tax authorities’ position regarding certain permanent establishment (PE) and VAT issues relating to foreign suppliers of digital goods and services to Israeli residents, and was drafted in light of the
OECD’s work on the BEPS project and its October 2015 release of the final reports on action 1 (addressing the challenges of the digital economy) and action 7 (preventing the artificial avoidance of PE status).
The circular makes public the ITA’s position on the manner in which certain tax principles should be interpreted, given the growing use of digital services and goods, and it focuses on three main topics:

  1. PE issues that arise from the cross-border sale of products and services through the internet;
  2. The attribution of income to PEs; and
  3. Internet services that require their foreign suppliers to register with the Israeli VAT authorities (VATA).

PE issues arising from the sale of products and services through the internet
In its clarifications relating to PE issues, the circular provides different rules applicable to residents of countries that have concluded a tax treaty with Israel (reciprocating states) and residents of other countries (nonreciprocating states).
Reciprocating states: The circular generally adheres to the currently accepted interpretation of the OECD model tax treaty, as reflected in the commentary on “fixed place of business” and “agency permanent establishment” under sections 5(1) and 5(5) of the model, respectively.
In addition, following the release of the BEPS action 7 report concerning PEs, the circular sets out the ITA’s interpretation of the types of activities that may benefit from the exemptions from PE status provided by section 5(4) of the model treaty for certain “preparatory or auxiliary” activities; in essence, the circular limits the scope of these exemptions. The circular provides the following:

  • A collection of activities, each qualifying for an exemption on its own, will be considered to constitute a PE if, examined together, the aggregated activities are not merely preparatory and/or auxiliary in nature.
  • Domestic operations involving activities not directly listed among the available exemptions may be eligible for an exemption only where their nature differs from the main business operations of the foreign enterprise and is considered inconsequential to the main goals of these operations.
  • Preparatory and/or auxiliary activities conducted by a foreign enterprise in conjunction with another activity that is considered one of the main business operations of the foreign enterprise will be deemed to give rise to a PE.
  • Operations conducted in Israel that are characterized by a significant digital presence (SDP) in Israel might not qualify for an exemption. Indications of an SDP could include a significant number of contracts signed with Israeli residents via the internet; services offered by the foreign enterprise that are used by many Israeli residents online; or where a foreign enterprise customizes its internet services to Israeli users. (This measure seems to go beyond the OECD’s recommendations under the BEPS project, which do not include an SDP as an element in determining the existence of a PE.)

Nonreciprocating states: The circular provides that activities of foreign enterprises that are residents of nonreciprocating states are examined by the tax authorities in light of the domestic source rules in the Israeli Tax Ordinance. The circular identifies three types of business operations that may be considered as producing business income that originates in Israel:

  1. Operations conducted through physical premises in Israel;
  2. Operations supported by an Israeli agent and/or representative; or
  3. Operations indicating the foreign enterprise has a “significant economic presence” (SEP) in Israel. Indications of an SEP could include the provision of online services relating to Israeli customers, a high volume of online transactions with Israeli customers, the provision of online services customized to Israeli customers, etc.

Attribution of income to PE
Reciprocating states: Under the circular, the income attributed to a PE of a foreign enterprise that is a resident of a reciprocating state must be determined based on the arm’s length principle. The methodology used must eliminate the effect of the interdependent relationship between the foreign enterprise and the PE, while accounting for the functions performed, the assets held and the risks assumed by the PE.
Nonreciprocating states: Where a foreign enterprise is a resident of a nonreciprocating state, the circular provides that the income attribution must be determined according to a methodology that accounts for the relevant functions, assets and risks.

VAT registration requirement
Under the Israeli VAT law, foreign entities conducting business in Israel are required to register with the VATA.
Generally, the import of goods (regardless of whether purchased online) into Israel by an Israeli importer would not require the exporter to register with the VATA; instead, the importer would have to pay VAT on the goods imported under a reverse-charge mechanism (regardless of whether the goods are tangible or intangible). However, the provision of online services to Israeli residents normally is considered as the provision of services in Israel (i.e. the conduct of business in the country), which requires the foreign supplier to register with the VATA and pay VAT.
The circular provides the tax authorities’ interpretation of the VAT law, as well as the “conduct-of-business” terminology in light of the digital economy, and concludes that the provision of internet services should be considered as business conducted in Israel if one of the following conditions is fulfilled:

  • The business activity of the foreign enterprise constitutes a PE in Israel for income tax purposes;
  • The foreign enterprise has established a “business mechanism” in Israel (e.g. has employees in Israel, a branch in Israel, an office in Israel, etc.);
  • An Israeli representative facilitates the foreign enterprise’s business activities in Israel, and such activities are auxiliary in nature (e.g. data gathering, maintaining or establishing business relationships, marketing, debt collection, advisory, customer service, etc.); or
  • The foreign enterprise has an SEP in Israel.

The tax authorities’ interpretation of what constitutes the conduct of business significantly expands the scope of foreign enterprises that potentially may be considered as conducting business in Israel, beyond the treatment that generally has applied in practice, and thus potentially subjects these enterprises to VAT registration, a requirement to charge VAT on the services they render and a VAT reporting obligation. The circular also clarifies that foreign enterprises conducting business in Israel should not be considered as foreign residents for certain purposes of the VAT law and, therefore, any Israeli dealers that provide services to such foreign enterprises must charge the full VAT rate (17%) on the services supplied, instead of the 0% rate applicable to foreign service recipients.

Source: Deloitte