Since Israel has a population of only 7 million, the local market is too small for many Israeli firms and the message is: export or die. Exporting usually follows an evolutionary process. For a novice exporter, it may be sufficient to make a sale from Israel and to ship his widgets to a distributor abroad; the distributor ought to know his own local market conditions best. If the Israeli exporting firm does business entirely from Israel, and not in the foreign country, it may avoid having a taxable presence in that foreign country and need only pay tax in Israel. A double benefit is sometimes possible - no tax abroad nor in Israel. This can apply to exporters with Israeli tax losses, for example, due to hi-tech research and development costs. This also applies to Israeli exporters who enjoy tax breaks as an Approved Enterprise or Privileged Enterprise, according to the Law for the Encouragement of Capital Investments, 1959. But it is not always clear when an exporter is doing business in a foreign country and becomes taxable there. Take the United States for example. The Internal Revenue Service (IRS) normally taxes foreign exporters who conduct a trade or business that is effectively connected to the US at federal rates of up to 35 percent plus state and local taxes. All this is a bit vague. To give greater certainty, Israel's tax treaty with the US allows the IRS to tax Israeli exporters who maintain a "permanent establishment" in the US. A permanent establishment is defined in detail in the tax treaty; generally, it means a "fixed place of business" (such as a branch, office, factory, store or sales outlet, construction or assembly project, or maintenance of substantial machinery for more than six months) or a "dependent agent" (agent with few other customers and/or concludes sales on behalf of the exporter). This can still be vague. For example, suppose you are an exporter of widgets to US customers using the Internet: Is there a taxable permanent establishment in the US? That is a tough issue, and the penalty for getting it wrong can be enormous. US tax regulations (1.882-4(a)(2)) provide that a foreign corporation may enjoy expense deductions (and certain credits) only if it "timely" files an income tax return. Such a return is timely only if it is filed within 18 months of the ordinary due date for the return. Suppose an Israeli company exports products or services to the US and files no US tax returns at all for many years because it thinks it has no permanent establishment in the US? If the IRS reviews things and concludes the Israeli company did have a permanent establishment, the Israeli company will be taxed in the US on its gross revenues, with no expense deductions or credits. For example: â€¢ US gross sales: $10 million â€¢ expenses: $8m. â€¢ net income not reported in the US on a timely return: $2m. â€¢ income taxed at 35% plus any state and local taxes: $10m. (not $2.). Recently this result was reaffirmed in a US Third Circuit Court decision - Swallows Holding, Ltd. v. Commissioner, of February 15, 2008. This decision reversed an earlier, more lenient, decision of the US Tax Court in 2006 (126 T.C. 96 (2006)). However, the decision was based on domestic US law, not tax treaty law. Therefore, what should Israeli exporters with US activities do? First, they should review their positions in light of this decision with US advisors. Second, Israeli firms with limited US activities should seriously consider filing timely US "protective returns" each year if there is any chance that such activities might constitute a US trade or business. For example, the return may claim an exemption from US taxes based on the US-Israel tax treaty. Who does this potentially apply to? Israeli exporters with warehouses or "dependent" agents in the US, among others. Also, non-US investment funds with an office in the US should keep in mind that there are many ambiguities under the Section 864(b)(2) no-trade-or-business exemption provision. To sum up, Israeli and other non-US taxpayers who opt not to file a US tax return because they do not believe they are engaging in a US trade or business, and think it is unlikely that the IRS will become aware of their US income streams, run the risk of being taxed on a gross-income basis and incurring penalties. Furthermore, if a taxpayer does not file a tax return, the US statute of limitations remains open. As always, consult experienced tax advisors in each country at an early stage in specific cases. email@example.com Leon Harris is an international tax partner at Ernst & Young Israel.