Israel has income tax treaties with more than 40 other countries. The main aims of tax treaties are to avoid double taxation and prevent fiscal evasion.
Double taxation is possible when a resident of one country derives income from another country and is taxable in both. The main methods for avoiding taxation are: foreign tax credits; an exemption in one or both countries; and consultations between the competent tax authorities of the countries concerned.
A well known tax planning technique is called, in tax slang, "treaty shopping." It usually involves routing income or gains through companies established in countries that have favorable tax regimes AND favorable tax treaties with other countries. The result may be little or no tax in ALL countries.
This is not exactly what the tax authorities in Israel and other countries have in mind as avoiding double taxation.
But can the Israel Tax Authority define and prevent the illegitimate use of tax treaties? A recent court case surprised everyone by saying it can, despite flaws in the tax law.
Artificial transactions: Section 86 of the Income Tax Ordinance allows an Assessing Officer to disregard a transaction if it is artificial or fictitious, or one of its main purposes is the avoidance of tax or an improper reduction of tax even if it is not against the law.
Tax treaty status: Section 196 of the Income Tax Ordinance appears to give preeminence to tax treaties over domestic law. Section 196 authorizes tax treaties and states: "When the finance minister announces in an order that an agreement [a treaty] has been reached with a particular country for giving relief from double taxation for income tax purposes and any other tax arising in that country, and that it is useful that the agreement take effect in Israel, the agreement shall take effect for income tax purposes notwithstanding any other legislation."
Does Section 196 override Section 86 and allow treaty shopping? This question was discussed by the Tel Aviv District Court in the case of Yanko-Weiss Holdings (1996) Ltd. vs Assessing Officer of Holon in a judgement issued December 30, 2007 (Income Tax Appeal 1090/06).
Briefly, in this case, a company was incorporated in Israel, but in 1999 its shareholders met in Belgium and resolved to make it a Belgian resident company by moving the registered office, management and activity to Brussels. The company also obtained confirmation of Belgian residency from the Belgian tax authorities. Subsequently, the company claimed a reduced rate of withholding tax (presumably 5 percent) under the Israel-Belgium Tax Treaty on a dividend from an Israeli resident subsidiary company. Presumably, the dividend may have qualified for a "participation exemption" for Belgian tax purposes, although the judgement does not discuss Belgian tax, only Israeli tax.
The District Court made reference to Article 31 of the Vienna Convention on the Law of Treaties of May 23, 1969, which states: "A treaty shall be interpreted in good faith in accordance with the ordinary meaning of the treaty in their context and in the light of its objects and purpose."
The use of the word "improper" in Section 86 of the Income Tax Ordinance regarding an artificial transaction fits in with the "good faith" doctrine of Article 21 of the Vienna Convention. Section 86 is not inferior or superior to tax treaties, but fits in with the basic premise of each tax treaty that it should not be abused, according to the District Court.
The court also quotes the OECD's commentary on its own Model Tax Convention on Income and Capital: "It is also a purpose of tax conventions to prevent tax avoidance and evasion." Belgium is a member of the OECD and Israel has begun the process of joining this organization.
The court implied (without explaining) that there was an artificial element in this case: "If the transaction had been conducted 'in the usual way' from an economic and business perspective, the Tax Authority would not have needed to prove it is artificial."
The court clarified that tax treaties are intended first and foremost to create a situation in which a taxpayer trapped in the tax system of two countries will not be exposed to double taxation. Tax treaties are not intended and cannot be construed as intended to be used in an abusive way, only in good faith and in the usual way, whether or not they contain express rules in this regard.
Therefore, the court ruled that the Israel Tax Authority is allowed to raise a claim of artificiality, notwithstanding the applicability of a tax treaty.
Comments: This was a District Court case. Let's hope the taxpayer appeals it to the Supreme Court because a number of issues were apparently not discussed in the present judgement. What was the taxpayer's rationale? What was artificial and why? Did the taxpayer have substantial operations in Belgium?
There have been a number of similar court cases in the UK in the last two years in which the taxpayer was successful - and Israeli tax law is derived from UK tax law. For example, in the case of Cadbury Schweppes Plc vs Commissioner of Inland, a UK-based group used an Irish company to provide group treasury services in Dublin. The European Court of Justice stated that the fact that an operation is capable of being carried on in the UK does not mean that it is artificial (ECJ case C-196/04 on September 12, 2006).
Should your Israeli company migrate abroad? The Yanko-Weiss scenario is less likely to occur now. In 2003, the Income Tax Ordinance was amended to impose a capital gains tax exit charge on anyone - individual or company - that stops being an Israeli resident (Section 100A). Also, a foreign resident entity is not entitled to any Israeli tax benefit, reduction or exemption as a foreign resident if Israeli residents hold 25% or more of any of the foreign resident entity's means of control; instead the Israeli residents must report the situation annually as "reportable tax planning" under Israel's tax shelter rules (Sections 68A, 131 (b1) regulations, 131(f) and 145A2). Furthermore, Israel now has rules for taxing deemed dividends of foreign passive "controlled foreign companies," among other things.
Should you try treaty shopping? Tax planning involving "treaty shopping" has become more difficult in recent years. Many of Israel's tax treaties now contain anti-treaty shopping rules. The Israel Tax Authority usually focuses on the issue in tax audits or when reviewing requests to make payments to foreign residents - otherwise the payer or his bank must withhold tax at source at rates of 20%-27%.
Some treaties contain "Limitation of Benefit" clauses that limit tax treaty benefits to residents of the two treaty countries who meet specified conditions - for example Article 25 of the Israel-US Tax Treaty.
Many treaties have "beneficial ownership" conditions that restrict tax treaty benefits to residents of the treaty country who are beneficially entitled to income received; the Israel Tax Authority interprets this to mean they are not mere "conduits" that pass the income on to others - for example Israel's tax treaties with the Netherlands, Switzerland and Singapore (see ITA Circular 22/2004 of August 26, 2004).
Most tax treaties have "effective management" clauses that prescribe that in cases of dual residency, a company will be deemed resident only in the country where its place of effective management is situated.
Some treaties limit tax treaty benefits to income or gains that are taxed in the recipient's country of residence - for example the Israel-UK Tax Treaty.
To sum up, tax treaties can be extremely useful in avoiding double taxation when structuring an international venture, but blatant treaty shopping that lacks commercial rationale may be challenged by the Israel Tax Authority.
As always, consult experienced tax advisors in each country at an early stage in specific cases.
Leon Harris is an international tax partner at Ernst & Young Israel.