Israeli businessmen are a "get-up-and-go" bunch - seeming to be genetically programmed to trading and investing globally. Some are even said to live on airplanes and only land to sign a deal or kiss the kids.
This article aims to give them a view from 36,000 feet of the main international tax issues to check out on any international investment venture. Such ventures may be related to a business operation or a real estate project.
It is difficult to generalize, but the key issues to consider typically include:
* The entity structure
* The business model
* Intellectual property and research and development
* Finance aspects
* Income repatriation
* Exit strategy
* Management and employees
* Double tax relief
* Tax planning and anti-avoidance rules
The entity structure needn't be overcomplicated - an Israeli parent company and operating subsidiaries may suffice, depending on the circumstances. Before 2003, an intermediate holding company in a country like the Netherlands was often interposed below an Israeli parent company, due to problems with Israel's foreign tax credit rules. Those rules have now been reformed and it is important to have no more than two tiers of companies below the Israeli parent company. This is because an Israeli parent company can only credit the corporate and dividend withholding taxes of its 25 percent-or-greater "daughter" companies and their direct 50%-or-greater subsidiaries ("granddaughter companies"). Also, the tendency to form a US parent corporation should be resisted in many cases as the US now imposes heavier taxes than Israel on operating profits as well as tax on intercompany transactions and balances under much-hated "Subpart F" rules in the US Internal Revenue Code
The business model needs careful consideration. Will all sales be negotiated and approved from Israel? Or will a local representative be empowered to negotiate and even sign a sales deal while a foreign customer is "in the mood?" In the latter case, the local representative will be considered a "dependent agent" and a "permanent establishment (ie branch) under most tax treaties and tax laws. This means the Israeli company is effectively doing business in that country via the local representative and must pay local taxes on the profit deemed attributable to that country. To improve efficiency and minimize differences of opinion, it often becomes necessary to establish a local sales or agency subsidiary company (see the article in this column Feb. 8, 2006: Exporters - Getting Started").
The local subsidiary companies each must be compensated on a reasonable "arm's length" basis for its functions, its assets and the risks they assume. Does the local subsidiary company own valuable intellectual property? Does it take title to the products being sold onwards to customers? What rate of taxes does the local subsidiary company pay? Does the Israeli company pay little or no Israeli company tax as an "approved enterprise" or a "privileged enterprise" on its share of profits? These are vital questions and the entire international business model must be framed to optimize the factors over both the short-term and the long-term. The "transfer pricing" strategy is the strategy for allocating income along these lines between related companies in a reasonable market-based manner. There are a number of sophisticated techniques for improving the operational and tax efficiency of a group's supply chain. Whichever strategy is adopted should be blessed by a transfer pricing study prepared by economists or even an advance pricing agreement with the relevant tax authorities in material cases.
Financing any venture is also extremely important. For example, most real estate projects tend to be leveraged (use borrowed funds). But sometimes the group has sufficient funds to re-invest - should it lend them to the local subsidiary concerned? Most countries have "thin capitalization" limits on interest expenses where the lender is a related company e.g. in the UK - typically interest expenses on borrowings of up to 70%-80% of the value of real estate may be considered deductible. In the US, a debt-to-equity ratio exceeding 1.5:1 can result in an interest expense denial. In addition, most countries impose withholding tax on interest payments to companies in other countries e.g. up to 30% in the US (but no more than 17.5% under the US-Israel tax treaty if the appropriate forms are filled out). A common problem is letting inter-company balances build up to finance local marketing expenses, in which case the above tax exposures may all materialize - and in the US and some other countries a deemed dividend (which exists only in the minds of the relevant tax authority) also may be taxable. Therefore, inter-company balances should be paid down and/or capitalized.
Income repatriation is clearly the name of the game. Can a local subsidiary company repatriate dividends or make other expense payments (e.g. consultancy fee payments) that are accepted for local tax purposes and, if so, what is the rate of local withholding tax?
In the US, dividends are generally subject to a 30% withholding tax, but this is reduced to 12.5% in the case of an Israeli parent company. Furthermore, what will be the combined tax effect given Israel's system of taxing worldwide income while giving a credit for certain foreign taxes? Detailed spreadsheet calculations of the combined taxes on operating profits (in the light of the transfer pricing strategy) and repatriated income quickly become a necessity. If an offshore tax haven entity is inserted into the group structure, will this help or will any benefit be countered by tax anti-avoidance rules in Israel or abroad?
If an offshore entity is under consideration, it may only help if it is active, has "substance" (own genuine employees, premises, assets, etc.) and manages itself. And the effect is usually to defer taxes on a portion of income (rather than exemption) until it is repatriated and/or distributed as a dividend. This is a complex area for separate discussion.
Expatriate employees relocated face a range of tax and other issues in each country. For example, people who cease to be Israeli residents are deemed to have sold their assets - including stock options - and must pay an "exit tax" upon departure from Israel or upon selling the assets concerned.
These and other issues need to be addressed - it is important to arrange medical insurance and tax consultations for expatriates in each country and to assist them with their expanded/new tax reporting obligations.
Last but not least, what is your exit strategy? The Israeli capital gains tax may range from 20%-49% in most cases. But are you hoping that the group will be acquired one day by a larger multinational? Are you hoping to take the group public on a stock exchange? Will the group sell its real estate or intellectual property and distribute you a large liquidation dividend? If so, before you fly off into the sunset, the present structure must make sense as investors are easily scared off. Therefore, the above factors should be considered with professional advisors in each country as your venture progresses.
The writer is an International Tax Partner at Ernst & Young Israel