At a time when Israel is preoccupied with elections, in the wider world, far-reaching things are happening. No, it’s not the coronavirus and its economic impact. Rather, there are changes in global taxation policies that threaten to hit Israel in its soft underbelly – the high-tech industry.
Last November, the Organization for Economic Cooperation and Development approved a draft proposal on new rules for taxing the digital economy. The draft was circulated to 130 countries, all of which signed on to the previous round of global tax changes known as BEPS, meaning base erosion and profit shifting – the practice of multinational companies moving their profits, wherever possible, to low-tax countries.
The new OECD rules will mark a revolution in how digital businesses are taxed, whereby the biggest countries are expected to profit at the expense of the small. In other words, countries like the United States, Britain and Germany, will be the biggest beneficiaries of the reforms; the biggest losers will be small countries with big high-tech sectors that rely heavily on foreign investment drawn in many cases by tax breaks. Israel is example no. 1 of a loser country.
The draft only states principles, without explaining the numbers. The devil is in the details, so Israeli officials are hoping against hope that they can succeed in improving these numbers in its favor. Because they have been reporting to a caretaker government for more than a year, senior officials have been leading the campaign without the help of Israel’s political leaders.
Their strategy has been to form alliances with other countries that will be hurt if the rules are put into effect. First and foremost on the list is Ireland, which has employed a very aggressive tax strategy to lure multinational tech companies. There are also a small number of Eastern European countries that face the same threat from the OECD rules. The problem is that a lot of Davids face multiple Goliaths.
- Intel bets on smart buildings in Israel to attract top tech talent
- Startup Nation is in peril: The Armis model could save it
- Thanks to last-minute Intel deal, Israeli tech exits doubled in 2019
The BEPS rules were implemented four years ago in response to the difficulties many world economies experienced in recovering from the 2008 financial crisis.
Looking for revenue
Governments needed to obtain more tax revenue to cope with sagging economies and bailouts. They ended up raising taxes on the middle class while big multinational corporations, such as Google, Facebook and the like, used aggressive tax planning to move profits to Ireland, Bermuda, the Isle of Man and Singapore, where tax rates are much lower.
Policymakers finally woke up to the extent of the problem when it was revealed that Apple had paid zero tax in Ireland. For the first time ever, rules on global taxes that covered most of the world’s countries were fixed. Among other things, they barred transferring profits from countries where research and development centers were located to lower-tax counties where the resulting intellectual property was registered.
Until the digital era, global tax rules had been relatively simple: Companies paid taxes in the country where their physical assets were located. The company’s home country, where it had its R&D centers or production facilities, captured most of the tax collected, even in the case of businesses whose operations spanned the globe. Other countries could collect taxes on a multinational’s local subsidiaries only.
In the digital age, when a multinational like Google has an R&D center in California, generates sales from all over the world and registers its IP in Ireland, the old system was becoming increasingly irrelevant.
Thus, in 2012, Google posted $10 billion of profits in Bermuda even though it was clear to everyone that the tiny island country wasn’t really where the money was made. Google simply moved the profits, it appears mainly from Europe, to reduce its tax bill. Until BEPS, it was all perfectly legal, even if it created huge economic distortions.
BEPS closed the loophole between where R&D was conducted and where it was registered, but it still left open the question of where profits originated. Does Google, which conducts most of its research in the U.S., need to pay taxes in France and Germany because their citizens use Google services and thereby create a lot of added value?
That question applies to all big digital businesses – cloud computing providers like Salesforce.com, online merchants like Amazon, apps like booking.com and streaming platforms like Netflix.
The new OECD undertaking says that from now on countries whose consumers are using such services are entitled to taxes from these companies. The draft says that these companies will have to pay taxes based on profits above a certain level generated from local revenues. The formula hasn’t yet been determined, but it is clear that big countries, with tens of millions of consumers, will capture most of the new taxes.
The principle is that in the case of giant companies, they will pay taxes on their ordinary profits to their home countries and taxes on windfall profits to the others.
It comes down to the details
How Israel will fare in the end depends on how the new tax system is structured, but officials have reason to be worried. They look at Israeli tech companies like Check Point and Nice, and worry that Israel will end up losing a large part of the taxes it now collects from them to other countries. (On the other hand, Teva Pharmaceuticals and Intel Israel don’t present a problem because their revenues are based on physical assets in Israel.)
But that’s not all. In order to end once and for all the phenomenon of tax shelters and the race to the bottom of countries competing with each other for the lowest corporate tax rate, the OECD wants to establish minimum corporate tax rates applicable throughout the world.
That bottom rate hasn’t yet been established, but the guess is it will be between 12% and 15%. If so, that is not good news for Israel. Under its Law for Encouraging Capital Investment, big export-oriented companies can qualify for just a 7.5% rate, or even 5% in the case of a very big enterprise like Intel.
Those tax breaks have been the subject of debate in Israel over the last 15 years, but it seems that the OECD is going to bring them to an end by making such super-low rates illegal. That is going to hit Teva and Intel Israel hard.
In the absence of the new tax rules’ details, it’s impossible to assess the impact they will have in Israel. On the one hand, the country will be able to tax companies like Intel on its local sales, but because we’re such a small country, those sales will be small and so will the tax take.
On the other hand, Israel stands to lose the tax revenues it’s collected from its most successful high-tech companies. This will add to the financial burden of tech companies, especially smaller ones, that now have to file and pay taxes to scores of countries. Without the Law for Encouraging Capital Investment, Israel will have a much harder time luring multinational companies to set up operations here.
Thus, a lot depends on Israel’s ability to mobilize a coalition of countries facing the same problems and lobby to raise the minimum sales turnover and profits that get hit with a local tax. Another solution would be to exempt digital companies that sell to other companies, rather than to consumers, from the tax. That would help Check Point and Nice.
Israel and its prospective allies don’t have a lot of time. The OECD is expected to settle on the rules by the middle of the year and put them into force in 2021. If they fail, there won’t be a lot of time left to adjust economic policies to the new tax regime.