Determining the Tax Residency of a Company in Israel

This is one of the key questions in international taxation, and it has practical implications for anyone holding a company incorporated outside Israel. To answer this question, four central concepts should be understood: the incorporation test, the control and management test, a controlled foreign corporation (CFC), and a foreign professional company (FPC).

The Israel Tax Authority closely examines companies incorporated outside Israel when they have a real connection to Israel. For example, such an examination may arise where the controlling shareholders are Israeli residents, where part of the management or decision-making takes place in Israel, or where the reports filed raise questions regarding the company’s actual place of management. In such cases, the question examined is whether the company is incorporated abroad only formally, while in practice its decision-making center, substantive management, or business activity is located in Israel. If that is the factual picture, the company may be classified as an Israeli tax resident company even if it was not incorporated in Israel. In addition, even where the company is considered a foreign resident, special Israeli tax regimes may still apply to it or to its shareholders in Israel, including CFC or FPC.

The determination of a company’s residency has broad practical significance. The classification may affect the actual tax liability in Israel, the scope of reporting obligations of the company and its shareholders, the applicability of tax treaties, the possibility of dual residency, and exposure to review by the Israel Tax Authority. Therefore, the place of incorporation is only the starting point, and in many cases a substantive analysis of how the company is actually managed is required.

Control and Management Test

When a company is incorporated outside Israel, one of the first questions the Israel Tax Authority will examine is where control and management over its business are exercised. This test is intended to identify the place where the company’s business policy is determined, where the material strategic decisions are made, and from which its activities are actually directed.

According to Income Tax Circular 4/2002, “Guidelines for the Control and Management Tests”, a formal examination of the place of incorporation, the identity of the shareholders, or the appointment of foreign directors is not enough. The test is substantive: it is necessary to examine where the ability to decide, influence, direct the business activity, and issue binding instructions with a decisive effect is actually exercised. In other words, the question is not only who is authorized to decide on paper, but who actually decides, where the material decisions are made, and where the company’s managerial center of gravity is located.

The main questions to be examined when determining whether a company is an Israeli resident or a foreign resident include the following, in accordance with the Israel Tax Authority’s guidelines:

• Where are the company’s material and strategic decisions actually made, and where does the process of formulating them take place, including the review of alternatives, consultations, and the final decision.
• Who is the person or body actually managing the company, and in particular whether the board of directors exercises independent judgment and makes the material decisions, or whether another person or body is in fact directing the company’s activities.
• Where are the company’s day-to-day management and daily operations actually carried out, including the issuing of instructions, handling suppliers and customers, approving payments, and monitoring the implementation of decisions.
• Where is the company’s business activity actually conducted, including meetings with customers, negotiations, commercial engagements, and material operational activity.
• Where are the company’s books of account, financial information, and accounting system kept and managed.
• Where are the company’s employees and key officers employed.
• Where are the company’s offices, assets, facilities, and operational infrastructure located.
• Where are the company’s material business relationships maintained, how does the company present itself to third parties, and how do business parties perceive its location and center of activity.
• Where are the company’s advisers, accountants, service providers, and professional support personnel located.
• To which tax authorities does the company report, and in which country does it present itself as a tax resident.
• Who are the actual controlling shareholders, and do they have veto rights or any real ability to influence the making of material decisions.
• Are there management agreements or arrangements with external parties, and what do they indicate regarding the identity of the party actually exercising managerial discretion.

If the totality of the circumstances indicates that the company’s real activity and the control and management of its business are exercised from Israel, the Israel Tax Authority may regard it as an Israeli tax resident company, even if it was incorporated outside Israel. Conversely, if the material decisions, day-to-day management, and actual business activity are carried out outside Israel, this may support the position that the company is a foreign resident.

For example, if a foreign company has a factory, an active office, a local bank account, local management, local suppliers, and local advisers outside Israel, and its operational and business management is actually carried out there, these factors may support the position that control and management are not exercised from Israel. Conversely, if most of the material decisions are in fact made in Israel, and the office holders outside Israel act merely as a rubber stamp, the Israel Tax Authority may argue that the company is an Israeli resident company.

From a practical perspective, already at the stage of establishing the international structure, it is important to ensure that the actual management patterns, the identity of the decision-makers, the location of the activity, and the corporate documentation are consistent with the desired tax outcome. Among other things, it is advisable to document meetings and material decisions, grant real authority to office holders outside Israel, and retain documentation showing where the decisions were actually made.

In this context, the supplement to Income Tax Circular 4/2002 emphasized that, in accordance with case law, it is necessary to examine the place where the material, fundamental, and important decisions concerning the company are actually made. Therefore, the appointment of foreign directors, the holding of a bank account outside Israel, the registration of a foreign address, or the existence of an office abroad do not, in themselves, prove that control and management are exercised outside Israel. It is necessary to examine whether there is a real business infrastructure: an active office, office holders with experience and authority, genuine discretion, and a substantive decision-making process that actually takes place outside Israel and is not merely for appearances.

In a corporate structure, the degree of influence of a parent company over decision-making in the subsidiary should also be examined. If it appears that the parent company in fact dictates the strategic decisions, and the subsidiary has no real autonomy but merely automatically approves decisions made elsewhere, an argument may arise that the place of control and management of the subsidiary is the place from which the parent company operates.

In addition, the control and management test also applies to holding companies and to companies whose activity consists of holdings and passive investments. Therefore, even where a company has no active manufacturing or commercial activity, it is still necessary to examine where the material decisions regarding its investments, holding structure, and asset management are made.

Existence or Absence of a Permanent Establishment in Israel

Even where a particular company is a foreign resident, this does not necessarily mean that it will not have a tax liability in Israel. The law may impose tax on a foreign company that has a permanent establishment in Israel, or on a company deriving income in Israel from commercial, service-related, or other business activity, depending on the circumstances of the case, the provisions of domestic law, and the relevant tax treaties.

As a general rule, income of a foreign corporation from the provision of services or from business activity connected to Israel may be subject to tax in Israel if it was derived in Israel. Where the foreign corporation is a resident of a country that has a tax treaty with Israel, it is necessary to examine whether its activity in Israel amounts to a permanent establishment. This will usually involve a fixed place of business available to the enterprise, or activity through a person in Israel who is authorized to conclude contracts on behalf of the enterprise or who plays a material role in the engagement.

In digital activity, the question of a permanent establishment is not examined only by reference to the existence of an office, branch, or fixed physical presence in Israel. It is also necessary to examine the manner of activity in relation to the Israeli market: whether persons in Israel are involved in identifying customers, managing customer relationships, collecting business information, negotiating, adapting the service to the Israeli audience, or supporting the local activity. The more material the involvement in Israel, the stronger the argument may become that the foreign corporation has activity that goes beyond marketing or support only, to the point of a permanent establishment in Israel.

Therefore, even where a foreign corporation has no traditional physical presence in Israel, a question regarding the existence of a permanent establishment may arise in certain circumstances. The examination will be carried out based on the totality of the facts, the provisions of domestic law, and the relevant tax treaty, if one exists. Not every connection to the Israeli market will create a permanent establishment, but significant, consistent local activity with business weight requires a professional review of the exposure.

Where the activity of a foreign resident in Israel amounts to a permanent establishment, reporting obligations in Israel may arise, as well as a tax liability on the profits attributable to its activity in Israel. In such a case, it is necessary to examine the scope of the local activity, the role of the persons operating in Israel, the manner of engagement with customers, and the attribution of profits to the permanent establishment, alongside the provisions of the relevant tax treaty.

Where a company may be considered a resident of more than one country, it is not sufficient to examine the domestic law of each of the countries. In such a case, the provisions of the relevant tax treaty should also be reviewed, and in particular the tie-breaker rules for cases of dual residency. In this context, decisive weight may be given to the place where the company’s effective management is located, or to the resolution mechanism set out in the treaty.

Is the Company a Controlled Foreign Corporation (CFC)?

Section 75B of the Income Tax Ordinance [New Version] provides that even where a particular company is not considered an Israeli resident, an Israeli resident controlling shareholder may still have a tax liability in Israel under the controlled foreign corporation regime. In essence, where the conditions prescribed by law are met and the controlled foreign corporation has undistributed profits derived from passive income, the controlling shareholder is deemed to have received a notional dividend equal to his or her proportionate share of those profits, even if the profits were not actually distributed.

To determine whether a company may be considered a controlled foreign corporation, it is necessary to examine whether several conditions prescribed in Section 75B of the Income Tax Ordinance [New Version] are met:

1. The company is a foreign resident body of persons.
2. The shares or rights of the company are not listed for trading on a stock exchange, or only a limited part of them has been issued to the public or listed for trading, in accordance with the conditions prescribed by law.
3. Most of its income in the tax year is passive income, or most of its profits derive from passive income.
4. The tax rate applicable to its passive income in the foreign countries does not exceed 15%.
5. The Israeli control conditions prescribed by law are met, including with respect to the holding percentage or the ability to influence material managerial decisions in the company.
6. In addition, for the actual charge to tax, it is necessary to examine whether there is also an Israeli resident “controlling shareholder”, as defined in the section.

Is the Company a Foreign Professional Company?

Under Section 75B1 of the Income Tax Ordinance [New Version], tax may be imposed in Israel on the profits of a foreign company where it is considered a foreign professional company. The regime is intended to address a situation in which activity in a special profession is carried out through a foreign resident body of persons, while substantively there is a significant Israeli connection to the shareholders and to the professional activity generating the income. Where the conditions prescribed by law are met, an Israeli resident shareholder who is a controlling shareholder in a foreign professional company may be deemed to have received a dividend equal to his or her proportionate share of the profits from a special profession that were produced or accrued outside Israel.

For the purpose of classifying a company as a foreign professional company, it is necessary to examine whether the conditions prescribed in Section 75B1 of the Income Tax Ordinance [New Version] are met, including the following conditions:

1. The company is a foreign resident body of persons.
2. If it is a company – it is a closely held company within the meaning of Section 76(a) of the Income Tax Ordinance [New Version].
3. 75% or more of one or more of its means of control are held, directly or indirectly, by Israeli resident individuals, in accordance with the calculation rules prescribed by law.
4. The controlling shareholders or their relatives, who together or separately hold, directly or indirectly, 50% or more of one or more of the means of control, perform services for the company in a special profession, directly or through a company in which they hold, directly or indirectly, means of control at a rate of at least 50%.
5. Most of the company’s income or profits in the tax year derive from a special profession.
6. A “special profession” is one of the occupations or professions determined in a closed list by order of the Minister of Finance, with the approval of the Knesset Finance Committee. The list includes, among other things, liberal professions and fields of expertise such as law, accounting, medicine, architecture, engineering, consulting, management, programming, advertising, communications, and additional professional occupations included in the order. Therefore, in each case, the list of professions set out in the relevant order should be reviewed, and a general assumption regarding the nature of the activity should not be relied upon.
7. For the purpose of the actual charge to tax, an Israeli resident shareholder who is a controlling shareholder in a foreign professional company is deemed to have received, as a dividend, his or her proportionate share of the profits from a special profession that were produced or accrued outside Israel, subject to the provisions of the section regarding the calculation of income, foreign tax credit, and an actual distribution of dividends.

Planning international activity through foreign companies requires a careful review of questions of residency, control and management, permanent establishment, CFC, FPC, and related reporting obligations. Because this is a complex and fact-dependent area, it is advisable to obtain specific professional advice before establishing the structure, during ongoing activity, and before filing reports with the tax authorities in Israel and abroad.

If you are setting up a company abroad, hold a foreign company, or wish to examine whether the company may be considered an Israeli resident, it is advisable to obtain advice from an expert in international taxation. Proper planning of the activity structure, the holding chain, the decision-making mechanisms, and the manner in which the company’s conduct is documented may reduce future disputes with the Israel Tax Authority. In appropriate cases, it may also be possible to consider applying for a pre-ruling from the Israel Tax Authority.

Nimrod Yaron & Co. has experience advising clients on matters relating to company residency, control and management, CFC, FPC, and reporting of holdings abroad. If you are setting up a foreign company, operating within an existing international structure, or wish to examine whether the actual management may be considered to be exercised from Israel, you may contact us for an initial review of the exposure, a professional opinion, the formulation of guidelines for continued activity, or an assessment of the possibility of approaching the Israel Tax Authority in a pre-ruling procedure.

For professional advice – contact us.