On Permanent Establishments and Taxes
Several international tax treaties of which Israel is a member incorporate the term ‘permanent establishment’. The term bears practical significance in matters concerning immigrant and returning resident tax. But what is a ‘permanent establishment’? By which criteria will a given establishment be defined as such? What should immigrants be aware of? What are they to take into account when relocating their business to Israel?
Article 7 of the ‘OECD Model Convention with Respect to Taxes on Income and on Capital’ reads as follows: “Profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein”. Consequently, in order to determine whether the other contracting state holds the right to tax certain business activities, it would have to be ascertained whether the firm in question will be regarded as one that holds a permanent establishment in the said country.
So, what is a permanent establishment?
A permanent establishment is defined in the aforementioned treaty as “a fixed place of business through which the business of an enterprise is wholly or partly carried on”. The term ‘fixed place of business’ includes, inter alia, a branch, an office, a factory, and more. In certain cases, more than one such permanent establishment may be attributed to a given venture; such is the case with the large multinational corporations that conduct substantial activities in numerous countries around the world.
By what criteria is an establishment defined a permanent establishment that is to be taxed by Israel?
In accordance with the interpretation of the OECD Model Convention, three cumulative conditions are to take place in order for the debtor’s activity in a given country to be regarded as conducted out of a permanent establishment:
- The debtor has a place of business in that state;
- The place of business is fixed;
- Management of the business is conducted by means of the said fixed place of business.
An exception to these conditions is made when the fixed place of business is used for purposes of storage, display, or the delivery of goods belonging to a resident. Moreover, the storing of equipment and basic machinery within the contracting state’s borders for a period not exceeding 6 months will not be considered a permanent establishment. In such a scenario, the enterprise will not be taxed by Israel.
What are the Difficulties that Arise?
In specific cases, identifying and locating the source of income may be difficult. The difficulty of determining what a permanent establishment is arises both with regard to multinational corporations whose activity is dispersed over numerous countries around the world, as well as with regard to a debtor operating in the global arena by means of a representative. In such cases, every state will argue the source of income is located in its own territory.
The term ‘permanent establishment’, one of the core terms in double taxation treaties, is intended to provide a solution to these problems. However, despite the broad and detailed definitions, the convention does not provide an effective, comprehensive solution for all problems that may rise. A prime example of one such problem is that of internet taxation.
Pursuant to amendment 168 (henceforth: the amendment) to the Israeli Income Tax Act (henceforth: the act), the Israeli Tax Authorities distributed the ‘income tax circular letter nr. 2011/1 (henceforth: the circular letter), listing tax benefits relevant to immigrants and returning citizens. The amendment is also known as ‘The Law for Encouragement of Immigration and Return to Israel’, and, as such, its purpose– also expressed in the circular letter – is to encourage immigration to Israel, bring back human capital to Israel, and encourage prospective investors to make Israel the centre of their lives, and consequently invest and contribute to the development of Israel’s financial sturdiness.
An individual that has returned to Israel after having conducted business abroad, including companies that are separate entities, will not be entitled to a tax exemption for that income which, according to the tax authorities, was generated after his move to Israel, from Israel.
An Israeli citizen’s business activity will constitute a permanent establishment in Israel of which the income will be taxed in and by Israel, and, as such and pursuant to article 4.1.5 of the circular letter, income generated from a dividend that is distributed to an individual of the management company, and which originate from income generated by the management company’s permanent establishment in Israel – will be regarded income generated in Israel, and will thus not be entitled to tax exemptions. The individual’s income that cannot be attributed to the company’s permanent establishment, and which was generated abroad, will be entitled to tax exemption in Israel, seeing as it will be defined as the income of a senior returning citizen.
By adopting the permanent establishment approach, the Israeli Tax Authority backed down, de facto, from its previously prevalent expansive approach with regard to tax exemptions for immigrants and returning citizens. This approach is even evident in legislation; namely, in Income Tax Act concerning control and management of foreign companies from Israel, according to which income generated by an immigrant or a returning citizen prior to his arrival in Israel, will be entitled to full tax exemptions in Israel. In so doing, it frequently misleads immigrants and returning citizens who are under the presumption that they are entitled to full and comprehensive tax exemptions pertaining to the income generated held outside of Israel, while deterring others from immigrating to Israel by instigating a certain friction between them and the tax authority itself.
In conclusion, the observation can be made that immigrants and returning citizens are re-examining the status of their foreign business activity and whether they meet the requirements that define an establishment as a permanent establishment before transferring their business to Israel. To this end, consultation with a specialist tax lawyer is highly advisable, so as to avoid developing tax debts in Israel for business conducted abroad.