YOUR TAXES: VAT on outsourcing abroad and fabless fabs

So the taxpayer tried a different argument – products are designed and developed in Israel and therefore intangible property (IP) is exported for use outside Israel – in Vietnam and the US.

Approximately 170,000 Americans live in Israel. In total, more than one million U.S. citizens and green card holders – who both live overseas and own more than 10% of a foreign corporation – faced the prospect of paying the tax. (photo credit: REUTERS)
Approximately 170,000 Americans live in Israel. In total, more than one million U.S. citizens and green card holders – who both live overseas and own more than 10% of a foreign corporation – faced the prospect of paying the tax.
(photo credit: REUTERS)
An Israeli court has issued a less-than-fabulous decision about outsourcing, drop shipments and fabless fabs – designing physical products such as furniture or electronic chips in Israel and fabricating/manufacturing them abroad for sale on international markets.
The Court ruled that 0% VAT may NOT apply in such cases. The standard rate of Israeli VAT is currently 17%.
In the modern world, this raises two questions – why and what are the rules? Unfortunately, the judge only answered the first question; we’ll try to do a bit better... (Mogogo Ltd vs. VAT Director Netanya, Lod District Court, 44963-03-17).
The Facts:
The taxpayer supplies food serving tables and trolley systems for professional caterers. The design is done in Israel, manufacturing is done by subcontractors in Vietnam using raw materials purchased in Vietnam. The products are then sold and shipped to customers in the US.
The tax issue:
Because the products are drop-shipped directly from Vietnam to the and do not pass through Israeli customs, 0% VAT for exported products does not apply under the Israeli VAT law and VAT on Israeli expenses is not recoverable.
So the taxpayer tried a different argument – products are designed and developed in Israel and therefore intangible property (IP) is exported for use outside Israel – in Vietnam and the US.
If so, the 0% Israeli VAT may apply under a different section in the VAT law.
But is there IP in such a case? The Israeli Tax Authority argued that physical goods are supplied outside Israel – tables and trolleys – not IP, and didn’t even bother sending a VAT official to check out the design office in Israel. Hence the court case.
The Case Decision:
The court deliberated the situation and ruled that in this case, no proof was supplied that IP indeed existed. The products had special features and commanded a higher price than other similar products, but the design work may perhaps have used common knowledge, not IP. To prove IP existed, the following is needed according to the court:
• The IP should be protected under IP law
• The IP protection should relevant to the goods concerned
• IP should be supplied, not just embedded in goods such as cars. (It is enough to allow use of the IP without selling the IP)
• If there is a patent, it should be registered in the taxpayer’s name. In this case, there was a patent applied for in the shareholder’s name, not the taxpayer company’s name.
Implications:
The decision exposes a flaw in the Israeli VAT law regarding if Israeli residents buy or manufacture goods in Vietnam or China, for example, and sell them on export markets – drop shipment or e-commerce – with or without design in Israel. This is very common.
It remains to be seen whether the court decision will be appealed.
What can be done?
A VAT circular deals with outsourcing in the area of software. The court and the ITA claim that the software has IP namely the software code, which may have copyright protection confirming the existence of IP.
If you are engaged in outsourcing and/or drop shipments of physical goods, consult lawyers and tax advisers about what is actually supplied and how this documented. In each case, review the Israeli income tax and VAT treatment.
If the design is done in Israel, one possibility to consider might be to enter into a separate agreement to sell or license the IP.
Another possibility to consider might be to provide separate design services.
A third possibility, beyond your control but it sometimes happens, is that the VAT Authority refuses to open a VAT registration on the grounds that the business is conducted abroad – but you must at least apply for a VAT registration if any part of the activity is conducted in Israel.
There may also be implications in the destination country to consider. For example, sales above prescribed levels to US states may be subject to US sales tax following a decision in 2018 of the US Supreme Court in the Wayfair case. Other destination countries may impose VAT or GST (goods and service tax) under their legislation.
Moreover, new income tax rules are being formulated by the OECD that may soon specify minimum taxable income levels in the supplier’s country of residence and/or in the consumer’s country.
To sum up, in all drop shipment and e-commerce cases, a fresh legal and tax review is needed.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd. [email protected]