Yesterday (April 11, 2016), the Israeli Tax Authority published circular 4/2016 concerning “Online Activities of Foreign Corporations in Israel”. The circular - which is groundbreaking in Israeli law - explains the scenarios in which a foreign entity will be taxed under the Israeli tax regime for its income originating from sale of goods or provision of services to Israelis over the Internet. The circular sets the groundwork for taxing foreign companies active in Israel via the Internet, including Internet giants like Facebook and Google.
 

Pursuant to the Israeli Income Ordinance, a foreign corporation’s business earnings arising from provision of services or sale of goods are subject to Israeli income tax if the income was generated in Israel. If a foreign corporation is situated in a country with which Israel has entered into a double taxation treaty, the foreign entity will be subject to Israeli tax only if its activities in Israel rise to the level of a ‘permanent establishment’. An establishment is defined in taxation treaties as either a physical, permanent place of business available for use by the foreign corporation, or a local agent of the corporation who is vested with the authority to execute contracts on behalf of the corporation (coined a  dependent agent’).
 

The circular explains that the physical location of the servers being used for Internet activity – a factor recognized in the past as suggestive of a permanent establishment – is less relevant nowadays given that servers can be physically situated virtually anywhere on earth, while at the same time activities such as marketing, service, support, development and others can be carried out elsewhere.
 

The circular goes on to explain that given the uniqueness of the digital economy, activities previously classified as merely preparatory or auxiliary (which did not give rise to a 'permanent establishment'), can nowadays be considered the mainstream activities of a corporation. For instance, a corporation with significant digital presence in Israel that, through a permanent venue in Israel, engages in activities previously regarded as preparatory or auxiliary, may from now on be considered as having a permanent establishment in Israel. The circular lists some factors indicative of significant digital presence in Israel such as concluding a sizeable number of service contracts with Israelis; services offered by the foreign corporation are consumed via the Internet by a large number of Israeli consumers; the corporation tailors its online services for Israeli consumers or users.

With respect to the alternative factor of a ‘dependent agent', the circular states that where a foreign corporation operates online with the assistance of affiliated Israeli companies or Israeli subcontractors, the Israeli agent may be deemed a dependent agent thereby creating an Israeli permanent establishment for the foreign corporation. The circular lists the following factors to be considered when determining this: lack of involvement by the foreign corporation in the transactions (indicating that the Israeli agent is de facto authorized to conclude transactions); where purchase orders received by the Israeli agent are routinely authorized by the foreign corporation; where latitude is given to the Israeli agent in offering prices and commercial terms binding on the foreign corporation; significant involvement of the Israeli agent in adjusting the contract to the customer’s needs and requests; where the Israeli agent is a party to the contract between the customer and the foreign corporation.

The circular also clarifies the circumstances in which foreign corporations providing online services to Israelis must register as an authorized merchant pursuant to the Israeli Value Added Tax (VAT) Law and report their activities accordingly. The circular provides additional guidance for foreign corporations situated in a country with which Israel does not have a double taxation treaty. {A copy of the circular (in Hebrew) is available here}.