Israel has a new stealth tax on digital products - what you need to know

This affects international exporters and Israeli importers of digital products.

 THE ISRAEL Tax Authority is apparently interpreting ‘mail’ to include email and downloads from the Internet.  (photo credit: OLIVIER FITOUSSI/FLASH90)
THE ISRAEL Tax Authority is apparently interpreting ‘mail’ to include email and downloads from the Internet.
(photo credit: OLIVIER FITOUSSI/FLASH90)

The Israel Tax Authority (ITA) has quietly started making Israeli banks withhold 17% VAT on imported digital products, such as books, movies and music, causing shock waves. This affects international exporters and Israeli importers of digital products.

The good old days

The Israeli VAT Law dates back to 1976, when digital products didn’t exist.

If an Israeli company imports physical products, such as books made from paper, the items pass through Israeli Customs at the port or airport. Customs then collects import taxes at applicable rates and VAT at the standard rate of 17%.

If the importer is a consumer (B2C, business to consumer), that person swallows the taxes.

Calculating taxes (credit: INGIMAGE)Calculating taxes (credit: INGIMAGE)

If the importer is a business (B2B or business to business), it will generally pay the import taxes and VAT and then recover the VAT on import as input VAT on its next VAT return.

Enter the Internet

If the importer buys a digital product, the product is zapped over the Internet and the importer downloads it to his or her computer. No Israeli Customs, no import taxes, no VAT.

Importers that are businesses typically want to be compliant, so they are allowed to issue themselves invoices on behalf of an unregistered foreign supplier. This is known in Europe as the “reverse charge” mechanism and is allowed in Israel under VAT Regulation 6D. The business importer pays 17% Israeli VAT on behalf of the foreign supplier and then immediately (or within six months) claims the same VAT back as input VAT on its next VAT return.

Enter the ITA

The ITA has apparently issued a secret instruction to Israeli banks, requiring them to disregard “reverse charge” invoices issued legitimately under VAT Regulation 6D.

This is apparently under VAT Law Section 26(b), which was amended in 1998 (not just now) to read: “Upon import of intangible (=digital) products, as well as newspapers, written documents and other printed matter, imported by mail, VAT shall apply when purchasing foreign currency at a financial institution to pay for their purchase, or upon transferring foreign currency to the seller [or] when giving the consideration.”

So, the ITA is apparently interpreting “mail” to include email and downloads from the Internet.

And Israeli banks are now starting to withhold 17% VAT from payments for imported digital products.

How does a B2B importer of digital products recover the VAT?

Section 38(a) of the VAT Law allows a business to claim input VAT on lawfully issued tax invoices, import declarations or “another document” approved by the ITA director. Israeli banks have started issuing “another document” and stopped recognizing reverse-charge invoices, without advising the new procedure.

More issues

The stealth VAT on e-commerce has yet to be formally announced. In our view, the law needs clarifying at the Knesset. And the ITA or the Israeli banks should inform the public of any new procedure.

There is a question about who bears the VAT withholding. If it is the Israeli purchaser, VAT refunds take time. If it is a foreign supplier not registered for Israeli VAT purposes, that supplier may forfeit the VAT altogether.

Worse still, what happens if the bank needs to withhold income tax (typically up to 25%) in addition to 17% VAT? Is that 25% of 117% of the price? We don’t yet know.

This matters because some digital products are licensed and not sold outright, and they may have a royalty element. For example, if you download a digital book or software to duplicate and circulate within Israel, there may be income tax to withhold of up to 25% because of the copyright.

Is there a solution? 

Check out tax treaties. For example, in the case of a Hollywood movie, the US-Israel tax treaty limits the withholding tax to 10% (or 15% for other industrial royalties). Israel’s other tax treaties also contain royalty withholding tax limits.

Do tax treaties override VAT withholding on top of income tax? 

That is an open issue. Tax treaties usually say which taxes they cover. For example, the US-Israel tax treaty covers “taxes imposed by the Israeli Income Tax Ordinance, by the Land Appreciation Tax Law… and other taxes on income administered by the government of Israel.”

So, a business importer of a movie or other digital products from the US might claim that Israeli banks can only withhold 10%-15% tax at source, whatever the tax is called.

What’s next?

This is a dynamic area, and readers should monitor further developments regarding VAT and e-commerce taxation generally. Check with your bank before paying for digital products.

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

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The writer is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd.