Taxation of e-commerce in Israel – income tax perspectives according to a draft circular of the income tax authority
The Israeli Tax Authority (ITA) published a draft circular concerning the taxation of foreign corporations that derive income from the provision of services via the internet to Israeli residents.
Such circular was published due to the need of the ITA to provide an interpretation of the Israeli tax legislation, in respect of income derived from e-commerce, so as to accommodate the substantial e-commerce activities taking place in or via Israel. The current definitions and rules, which relate to terms such as permanent establishment or place of doing business, have been commonly used in respect of brick and mortar businesses, and the need has arisen to provide an interpretation for such terms so as to allow them to appropriately be applied to the digital economy.
However, despite the need to provide an all-encompassing solution, the ITA specifies that the draft circular applies only to situations in which a foreign corporation provides services (as opposed to products) via the internet to Israeli residents, and specifically where such corporation uses an affiliated Israeli company that performs various tasks for it. The ITA notes that additional issues may be reviewed in the future. In this article, we will focus solely on income tax issues. However, it should be emphasized that the draft circular deals also with VAT issues. These will be reviewed in another article that will be published in the near future.
The draft circular first analyzes what will amount to a fixed place of business for the purpose of creating a permanent establishment. In this respect, it is noted, rightfully I may add, that very limited importance should be attached to the location of the server, if at all, and that a permanent establishment can exist in a jurisdiction in which the servers are not located.
The draft circular clarifies that where (a) the core activity of the foreign corporation is performed via the internet, (b) the foreign corporation uses a facility in Israel, and (c) where the following criteria, in part or in full, exist, then the foreign corporation’s online activity may create a permanent establishment in Israel for that foreign corporation:
- On top of the facility in Israel, the foreign corporation operates a website that is fitted for the use of Israeli customers (through the use of language, ads, style, currency etc.);
- The website links between an Israeli customer and Israeli suppliers;
- The popularity of the use of the website by Israeli users is high;
- The profit that can be generated from the website increases with the rise in the number of users of the website and their activity;
- Representatives of the foreign corporation in Israel are involved in locating customers or collecting information, with the aid of the Israeli facility;
- Customer relationship management – ongoing relationship between the foreign corporation’s representatives and the Israeli customers, with the aid of the Israeli facility; such includes, inter alia, organizing customer conferences, creating opportunities for the introduction of new products, development and modification of the customer service, providing feedback in respect of the activities of the foreign corporation in the local market etc.
- The scope of the marketing and support services provided in Israel by the foreign corporation’s representative is significant;
- The foreign corporation faces business risks in Israel.
The draft circular further clarifies that facilities of an affiliated Israeli corporation that are at the disposal of the foreign corporation, that are used by the foreign corporation for the purpose of generating income which is not income of the Israeli company, may be considered in certain circumstances as facilities of the foreign corporation.
In addition, according to the draft circular, an employee of an Israeli corporation, who operates in accordance with the instructions of the foreign corporation, may be considered as an employee of the foreign corporation or as acting on its behalf and thus create a permanent establishment for the foreign corporation.
The scope of the foreign corporation’s involvement in the recruitment of Israeli employees and in determining their employment terms might create a permanent establishment for the foreign corporation.
The ITA suggests that a broader interpretation of the term “permanent establishment” might be adopted in the future, so as to tax in Israel a purely online activity of foreign corporations, where these corporations have a significant digital presence in Israel. Such interpretation, if adopted, will be applied where, for instance, (a) a significant number of contracts for the provision of digital services is executed between the foreign corporation and Israeli residents, (b) the services of the foreign corporation are broadly consumed by Israeli residents, or (c) the foreign corporation receives substantial payments from Israeli residents in connection with contractual obligations for the provision of a service which is a part of the core activity of the business of the foreign corporation.
As to the alternative of having a permanent establishment on the basis of the existence of a dependent agent, the draft circular notes that in some instances, a local corporation or agent could be considered a dependent agent and create a permanent establishment for the foreign corporation, if the agent is in fact contracting in the name of the foreign corporation. In order to determine this, the following factors, inter alia, will be taken into account:
- The scope of authority granted to the agent to intervene in the negotiations between the Israeli customer and the foreign corporation;
- Whether the agent is authorized to provide the customer with any price and commercial terms in a manner that binds the foreign corporation, regardless of whether these are dictated in advance or whether the agent has discretion to determine them;
- Significant involvement of the agent in tailoring the contract for the needs and requirements of the customer;
- The agent’s authority to provide benefits;
- Whether the agent is a party to the contract between the foreign corporation and the customer.
The draft circular provides that where the contract with the Israeli customer is a uniform contract, without any possibility for meaningful negotiations, such contract will be reviewed in accordance with its terms and the direct contribution of the agent to the execution of the contract.
All of the above will be reviewed, and where it is found that the involvement of the agent in the negotiations is high, and that its decisions bind the foreign corporation, it is more likely that the conclusion will be that this agent is a dependent agent that creates a permanent establishment for the foreign corporation.
The draft circular is a major development in the sphere of Israeli taxation of e-commerce, and represents the first time that the ITA has attempted to take a real look into the taxation of the digital economy. While it is disappointing that the ITA failed to provide a comprehensive solution in this context, but rather focused on a limited part of this economy, there is no doubt that this draft circular presents a major development that needs to be carefully reviewed by all stakeholders. It is highly recommended that relevant stakeholders will take legal advice as to the potential ramifications this draft circular might have on their activities, operations and structure, and prepare themselves for the changes ahead.