In the global era, businesses operate beyond the borders of their country of residence and conduct commercial and economic activity in various countries. One of the key issues in international taxation is whether a permanent establishment exists. The determination of whether a business has a permanent establishment in a country has broad implications for its tax liability. This determination is a fundamental principle of international tax law and of double tax treaties, as it affects which country has the right to tax.
Tax Liability in Israel and the Place Where Income Is Derived
Israeli tax principles establish basic rules regarding tax liability in Israel:
- Israeli residents: liable to tax in Israel on their income, whether derived in Israel or outside Israel.
- Foreign residents (individuals and corporations): liable to tax in Israel only on income derived in Israel.
With respect to business income, the place where the income is derived is determined according to the place where the business activity is carried out. Tax liability in this respect depends on whether a tax treaty exists between the State of Israel and the taxpayer’s country of residence (whether an individual or a corporation):
- Where the taxpayer is from a country that does not have a tax treaty with Israel: the business activity in Israel will be subject to Israeli tax from the outset.
- Where the taxpayer is from a country that has a tax treaty with Israel: in order for the business activity to be subject to Israeli tax, a permanent establishment must exist in Israel.
Definition of Permanent Establishment
The term permanent establishment originates in double tax treaties. According to the definition in the Model Convention of the Organisation for Economic Co-operation and Development (OECD), a permanent establishment exists where one of the following alternatives applies:
- Fixed place of business: where the foreign corporation conducts business activity in the source country through a fixed place of business. For this alternative to apply, three cumulative conditions must be met: first, there must be a physical place of business, such as a factory, store, or office. Second, the physical place of business must be fixed. Third, the business of the foreign corporation must be carried on through that fixed place of business.
- Dependent agent: where business activity is carried out in the source country through a dependent agent. This agent has authority to conclude contracts on behalf of the foreign corporation. For this alternative to apply, the person who is a dependent agent must have three characteristics. First, the person, including an incorporated entity, must have authority to bind the foreign corporation in contracts. Second, the authority must be exercised habitually and regularly. Third, the authority to sign contracts must relate to activities that form part of the business activity.
- Construction site or installation project: a construction site, construction project, or installation project constitutes a permanent establishment only if it continues for more than the number of months specified in the treaty. In most treaties, this period is 12 months.
It is important to note that the mere fact that one company controls another company, or is controlled by it, does not turn either company into a permanent establishment of the other. In other words, a foreign parent company will not be considered to have a permanent establishment in Israel merely because it has an Israeli subsidiary, and vice versa. This is an important clarification that appears in most tax treaties between countries.
The advantage of a tax treaty in the context of a permanent establishment is that where a foreign company is resident in a country with which Israel has a tax treaty, and its activity in Israel does not rise to the level of a permanent establishment, it will not be taxed. By contrast, where a foreign company is resident in a country with which Israel does not have a tax treaty, in principle, any business activity may be subject to tax in Israel.
Exceptions to Permanent Establishment
The Model Convention provides exceptions to permanent establishment:
- Use of facilities or maintenance of goods solely for the purpose of storage, delivery, or display.
- Maintenance of goods for processing by another company.
- Maintenance of a fixed place of business solely for the purpose of purchasing goods or collecting information, or for any other activity of a preparatory or auxiliary character only.
International Tax Liability and Permanent Establishment
Where a permanent establishment activity exists, the source country is entitled to tax with the primary taxing right. By contrast, the country of residence has a residual taxing right, but it will be required to grant a credit for taxes paid in the source country.
Summary
Understanding the concept of permanent establishment and its tax implications is essential for any business operating in the international arena, and for any individual with cross-border economic activity. Smart tax planning can save businesses significant costs. Among other things, such planning can help foreign corporations avoid creating a permanent establishment in Israel and thereby avoid paying high tax.
Nimrod Yaron & Co. – Israeli and International Taxation has extensive experience advising businesses on permanent establishment matters.
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Questions and Answers
Do digital businesses have a permanent establishment?
Yes, under certain conditions. Article 5 of the Model Convention defines a permanent establishment as a fixed place of business through which the business of the foreign corporation is carried on, in whole or in part. In the context of the digital economy, the electronic commerce environment must be examined. The Commentary to the Model Convention recognizes the physical location of the server that supports the website as a physical place that may serve as a permanent establishment.
However, this interpretation does not rule out the existence of additional permanent establishments in other places where economic activity is carried out, even if no server is located there. In the digital world, the server may be physically located in a place that is different from where the business conducts its marketing, support, service, and other activities. Therefore, relatively limited weight will be given to the permanent establishment at the place where the server is located.
How should a permanent establishment report?
Where it is determined that the activity of the foreign corporation rises to the level of a permanent establishment in Israel, it will be required to report separately on the income it derived in Israel. The total profit derived in Israel and attributed to the activity in Israel will be determined in accordance with transfer pricing rules.
What are the tax implications of a permanent establishment for a veteran returning resident?
A veteran returning resident is a person who returns to Israel after having been a resident of a foreign country for ten years or more. A returning resident is entitled to significant tax benefits, including a tax exemption on income derived outside Israel for ten years from the date of returning to Israel. The exemption also applies to income from a permanent establishment that the veteran returning resident has abroad. This means that income from that permanent establishment will be exempt from tax in Israel throughout the benefits period.
However, the structure of the business activity abroad should be carefully examined before returning to Israel, with proper tax planning by tax experts. This is in order to maximize the benefits and ensure that the activity of the veteran returning resident meets the conditions for receiving the exemption.
