Your Taxes: Tax ruling has international effects

The Israel Tax Authority (ITA) has published a tax ruling (number 1312/12) that will affect joint ventures between Israeli and non-Israeli firms. Action should be taken as briefly discussed below.

The facts

In this case, an Israeli trading company intended to set up an unregistered partnership (joint venture, or “JV”) with a foreign company resident in an unnamed country that has a tax treaty with Israel. Ownership, income and expenses of the JV would be split 50:50 between the two companies. The purpose of the JV was to develop communications products in the other country using people resident there. The JV would then go for global sales. The planning, marketing and advice to clients would take place in Israel.

Nevertheless, part of the marketing would take place “directly and/or by means of regional agents or distributors.” None of the shareholders of the foreign company were ever Israeli residents. No intellectual property would be transferred to the JV or the shareholders of the Israeli company, directly or indirectly.

The ITA’s ruling

The ITA ruled that the JV represents a taxable “permanent establishment” (see below) of the foreign company in Israel according to the tax treaty of its country of residence with Israel. This means the foreign company must open an Israeli tax file, file Israeli tax returns and pay Israeli tax on income attributable to the permanent establishment. And to make sure, the Israeli company is “assessable and chargeable” to Israeli tax as a representative of the foreign company, pursuant to Section 108 of the Israeli Income Tax Ordinance.

The allocation of profits for Israeli tax purposes between Israel and elsewhere would not necessarily be 50:50; it would be according the transfer pricing rules in the Israeli tax law and the relevant tax treaty.

The ruling had another twist. Employees of the foreign company would also be taxable in Israel according to the relevant tax treaty.

Finally, the ruling lays claim to Israeli capital-gains tax should the JV ever be sold, in accordance with the Israeli tax law and the relevant tax treaty.

Implications

This ruling is bad news for Israeli and foreign businesses and their employees. Many international deals are structured as JVs for a variety of commercial reasons: to create synergy, use the other party’s connections, and so forth.

If double tax arises, the foreign company may be able to claim a foreign tax credit for the Israeli tax, but not always; e.g., if the tax authority in the foreign company’s home country disagrees that a permanent establishment exists in Israel. And the foreign company may not want the administrative bother of tax reporting in Israel in Hebrew on approved Israeli accounting software, in addition to reporting in its home country.

Furthermore, not discussed in the ruling is the possibility that the Israeli company and its employees might be deemed to be taxable in the other country concerned, applying the same principles.

What is a permanent establishment?

Israel is a member of the Organization of Economic Cooperation and Development (OECD), and Israeli tax treaties generally follow the OECD model tax-treaty definition.

This essentially says: The term “permanent establishment” means: a fixed place of business through which the business of a foreign enterprise is wholly or partly carried on; or a “dependent agent” acting on behalf of a foreign enterprise that has, and habitually exercises, in Israel or the other treaty country concerned, an authority to conclude contracts in the name of the foreign enterprise.

What went wrong in this case?

The ruling does not say why a permanent establishment was deemed to exist. We can only guess that the foreign company had use of offices in Israel, or that the Israeli company was expected to habitually sign sales agreements of the JV in Israel.

What should others learn from this ruling?

We don’t know why the JV structure above was adopted; it might have been to save costs. It was probably not to reduce Israeli tax, as there are usually easier ways of arriving at a similar tax result.

Nevertheless, international concerns thinking of entering into a JV with an Israeli company should beware of various potential obstacles, including: using a partnership (registered or unregistered, see below); sharing profits and losses; signing JV sales in Israel.

In practice, such international JVs are usually structured differently.

Precedents

Surprisingly, there are at least two similar precedents where havoc was eventually averted. First, the ITA made similar claims a decade ago against international venture-capital funds that invested in Israel, costing Israel billions of investment dollars. These involved limited partnerships registered in Delaware and elsewhere. Eventually, the ITA backed down and made a pact with the VC funds.

And in the 1980s in the UK, international investors stayed away from the City of London because of the same provision as Israel’s Section 108 in the UK tax law.

The UK government headed by Margaret Thatcher had to change the law to help save the London financial industry.

To sum up

International JVs involving Israeli companies may need restructuring in light of the ITA’s misguided ruling.

As always, consult experienced tax advisers in each country at an early stage in specific cases.

leon@hcat.co

Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.