Israel‘s trade and commerce with the rest of the world is supported by income-tax treaties with 50 other countries.
One of the many reasons for Israel‘s economic success is that its trade and commerce with the rest of the world is supported by income-tax treaties with 50 other countries, as well as an array of free trade agreements, R&D pacts and social-security totalization treaties.
But are the income-tax treaties fairly applied by Israeli tax officials? If there was any doubt in the past, it is important to note there is a new tax sheriff in town, in the unlikely guise of the Organization for Economic Cooperation and Development (OECD). Israel joined the OECD last September. Below is an overview of the anticipated implications.
What is the status of tax treaties in Israel?
According to Section 196 of the Income Tax Ordinance, the finance minister can give effect to a tax treaty whenever he deems it useful, and this will prevail over any other law. Tax treaties matter because international trade accounts for a relatively large part of Israel‘s GNP.
What does the OECD do?
The OECD has 34 members, including Israel. Its mission is to promote policies that will improve the economic and social well-being of people around the world. A Finance Ministry press release last May predicted that Israel‘s accession to the OECD would have the following ramifications:
Attract foreign investors
Positive influence on Israel‘s credit rating
Compliance with OECD standards for activities in international markets, including OECD tax agreements and anti-corruption rules
Learning from the ‘‘best practices‘‘ of member countries in the organization
Analyzing social needs and establishing ways to decrease inequality and social gaps
Implementing reforms in the area of environmental protection.
How will the OECD affect our fiscal policy?
The OECD publishes a model tax treaty and commentary that give guidance to governments and taxpayers about similar actual tax treaties. In addition, the OECD has guidelines regarding transfer pricing between related enterprises.
The introduction to the OECD model convention states: ‘‘Member countries, when concluding or revising bilateral conventions, should conform to this Model Convention as interpreted by the Commentaries thereon and having regard to the reservations contained therein… and their tax authorities should follow these Commentaries, as modified from time to time… subject to their observations thereon.‘‘
The Israel Tax Authority has itself issued a Circular (17/2003) that says: ‘‘It is accepted to regard commentary published by the OECD as the accepted commentary in the international arena.‘‘
Therefore, it seems that if the Israel Tax Authority disagrees with the OECD commentary, it must now apply the OECD commentary unless the Israeli government has entered a reservation or observation.
This is a major development that seems likely to influence the administration of Israeli tax law if Israel is to meet its obligations to the OECD.
Israeli reservations about OECD Model Tax Treaty
So far, the Israeli government has entered only a few reservations or observations on the OECD model convention.
Two notable reservations state Israel‘s intention to include trusts in the definition of a ‘‘person‘‘ covered by Israeli tax treaties. This is despite a trust being defined in the Israeli Trust Law and Income Tax Ordinance as an ‘‘arrangement‘‘ (not a separate legal person) whereby someone holds assets for someone else.
Also, Israel reserves the right to insert a provision whereby a permanent establishment (taxable fixed place of business) shall exist if an installation, drilling rig or ship are used for activities connected with the exploration of natural resources.
How does the OECD benefit the taxpayer?
The OECD model commentary may be relevant in two ways: by providing guidance on aspects not covered by Israeli tax law or treaties; and by counteracting any less-than reasonable interpretation by the Israel Tax Authority.
Below are a number of examples regarding situations likely to be controversial in Israel.
Since ‘‘there is nothing new under the sun,‘‘ many of these controversies have already been addressed by the OECD model treaty commentary, in particular in a 2010 update.
Until now, mutual funds and other investment funds have faced difficulty in obtaining treaty benefits (reduced withholding tax rates or exemption) in countries where they invest, because such funds typically have many investors from many countries. Also the investment fund may be established as a unit trust or a company or a limited partnership.
For example, how can a fund quickly claim treaty benefits ahead of a declared dividend distribution? The OECD model treaty commentary clarifies that widely held ‘‘collective investment vehicles‘‘ should be treated as resident for treaty purposes in the country where they are established, to the extent of their ‘‘equivalent beneficiaries.‘‘
An ‘‘equivalent beneficiary‘‘ is a resident of the same country, or another country that: (a) has a tax treaty with the income source country, with effective and comprehensive information exchange rules; and (b) the tax rate is the same or lower under a treaty or domestic law.
According to the OECD, it is sufficient to check the applicability of these conditions ‘‘no more often than the end of each calendar quarter,‘‘ or take it for granted if the fund is publicly traded in the country where it is established. Pension funds and sovereign wealth funds may also be expressly exempted.
The Israel Tax Authority needs to be satisfied upfront about eligibility of foreign investors to treaty benefits or to a domestic capital-gains tax exemption upon a sale of Israeli securities. Otherwise the regular withholding tax rate for foreign residents of 25 percent is typically applied.
With regard to foreign hedge funds that have an Israeli resident manager, benefits have been granted in the past regarding foreign investors, but such applications are rigorously scrutinized at present. It seems the OECD 2010 update will be helpful in Israel.
Israel doesn‘t have any specific rules on this, but the OECD model convention and commentary do. According to the OECD, a permanent establishment does NOT include an Internet site, ISP hosting, providing a communication link, advertising of goods and services, relaying information through a mirror server, gathering marketing data and supplying information over the Internet. But a permanent establishment does include an unmanned server engaged in e-tailing sales and commerce over the Internet.
The question has often arisen whether a satellite in orbit could be considered a permanent establishment (taxable fixed place of business) in the receiving country. The OECD model treaty commentary clarifies that no member country would agree that the location of these satellites can be a part of the territory of a country under the applicable principles of international law.
Also the area over which a satellite‘s signal can be received (the satellite‘s ‘‘footprint‘‘) cannot be considered to be a place of business of the satellite‘s operator. Even if the customer ‘‘leases‘‘ a satellite transponder, this is really a services transaction and is not taxable as a lease transaction, according to the OECD.
Telecommunication roaming agreements
It is common for telecom operators of one country to enter into a ‘‘roaming agreement‘‘ with a foreign operator to allow its users to connect to the foreign operator‘s telecom network. The OECD model treaty commentary clarifies that under a typical roaming agreement, the home network operator does not have physical access to that network and cannot therefore constitute a permanent establishment of that operator.
Cable, pipeline, other equipment in Israel
With regard to a cable or pipeline that crosses another country, the OECD model treaty commentary clarifies that a customer whose data, power or property is transmitted merely obtains transmission or transportation services, not access to a pipeline or cable. In consequence, the pipeline or cable cannot be considered to be a permanent establishment of the customer – nor of the operator if the operator merely delivers its own property.
Even if the customer ‘‘leases‘‘ a cable, this is really a communication-services transaction and is not taxable as a lease transaction. By contrast, the US-Israel Tax Treaty deems the presence of substantial equipment or machinery for more than six months to be a permanent establishment, and the Israel Tax Authority sometimes applies this principle to equipment owners from other countries too.
It remains to be seen whether the OECD clarification regarding cable and pipelines will change the Israel Tax Authority‘s approach to equipment of a foreign party in Israel.
What‘s in it for the Tax Authority?
The Israel Tax Authority may also gain from the OECD accession:
The OECD model treaty commentary has a discussion on preventing ‘‘treaty shopping‘‘; i.e., use of a tax treaty between two countries by a resident of a third country. The OECD Commentary says: ‘‘States do not have to grant the benefits of a double-taxation convention where arrangements that constitute an abuse of the provisions of the convention have been entered into.‘‘
Most tax treaties exempt visiting personnel from local tax if they are present less than 183 days in the tax year and employed by a foreign resident employer and their cost is not borne by a local permanent establishment.
The OECD model treaty commentary tightens up this requirement by saying it is a matter of domestic law whether services are rendered by an individual in an employment relationship.
This involves focusing primarily on the services rendered and their integration into the business carried on by the enterprise that acquires their services. So if a visiting individual effectively has an employment relationship with an Israeli customer, the individual may forfeit any treaty exemption from Israeli tax he may otherwise have enjoyed.
The OECD provides its own employer-employee relations tests, including: authority to instruct, responsibility for the work place, salary recharge, supply of tools and materials, determination of the number of individuals and their qualifications, right to select personnel, right to impose disciplinary sanctions, determination of holidays and work schedule.
To sum up, Israel‘s accession to the OECD is likely to help taxpayers and the Israel Tax Authority to better understand the meaning of Israel‘s tax treaties. This is likely to impact any request to invoke a tax treaty.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
Leon Harris is a Certified Public Accountant and tax specialist at Harris Consulting & Tax Ltd.