Israel plans to change how it assesses the tax liability of Internet companies like Google and Facebook, aiming to collect tax based on actual business activities in the country, according to a circular issued Thursday by the Tax Authority.
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The crux of the change, likely to go into effect later this year, calls for taxing profits made in Israel regardless of the location of a company’s servers. The policy will be implemented as a revised interpretation of existing tax law, so it won’t require new legislation.
“We consider this a new interpretation of existing laws, so the changes can be applied immediately after reviewing comments by the public,” a tax official who requested anonymity told TheMarker.
Until now, Internet companies have paid taxes mainly in countries in which their servers are situated, a policy that many governments are challenging on the grounds that it deprives them of tax revenue.
“Against the background of developing digital economies, in which a server can be situated almost anywhere ... one can assume that a ‘permanent establishment’ created by the server will only entail limited profits,” the authority said.
In acting now, Israel is stealing a march on the OECD, which in August is expected to publish a draft of guidelines on how multinational web businesses should be taxed, with the final version due at the end of the year.
Israeli tax officials don’t plan to implement the reform unilaterally. They’ve been talking with multinational Internet companies with operations in the country, and some or all of the public comment will be heeded. But legal sources say the authority is already reviewing how it will assess taxes on Google and Facebook.
The authority won’t abandon the cost-plus system, which it uses mainly for taxing the 200 or so foreign companies with R&D centers in Israel. The authority once objected to this system, which will now be adjusted to typical profit levels in the industry.
Cost-plus is a standard method used in the Internet business for taxing subsidiaries that provide services like R&D to a parent company.
The method doesn’t actually address the subsidiaries’ profits — it’s based more on their expenses and then adds an arbitrary 5%-10% profit to calculate what taxes are owed based on typical corporate tax rates.
The authority’s new criteria will contain a new interpretation of the concept of a “permanent establishment” whose location determines the country where taxes are paid. The current method, under which Internet companies are taxed mainly by the location of their servers, dates from when servers were physically close to their users. But new technologies let businesses situate their servers in tax havens.
The server’s location will be given some consideration in assessing taxes owed, but much more weight will be given to the business activity a company engages in locally such as marketing and search service.
“The location of the permanent establishment could be one in which there are no servers,” added the authority.
Tax criteria for Israel will include that a facility is located in Israel or a site operated from Israel, adjusted to Israeli customers in terms of language, advertising, style and currency. Other considerations include whether the site connects suppliers to Israeli customers and the site's popularity among Israelis.
An Israeli company’s facilities that are placed at the disposal of a foreign company and used by it to generate profits will under certain circumstances be considered foreign facilities and taxed that way, the authority said.
A salaried employee of the Israeli facility could be considered an employee of the foreign company, giving it the status of a permanent establishment. Significant involvement of a foreign company in recruiting Israeli employees could deem it a permanent establishment for tax purposes.
A Tax Authority official said his people had no idea yet how much tax the government would be collecting from the policy change. He said the change was relevant mainly to companies targeting Israeli customers directly through the Internet, not companies like eBay that have a global site also used by Israelis.
“We said that if we determine that there is a permanent establishment in Israel, it will be taxed for activity in Israel based on parameters such as a Hebrew website, or the extent of activity by Israelis on the website,” the official said.
“Profits must be proportionately attributed to this permanent establishment in relation to its total global activities. There are several ways of doing this, and requests by different companies will be considered. By publishing these new criteria we’re one step ahead of the OECD.”
Regarding value-added tax, the authority already requires that a foreign company with significant activity in Israel register as a business and pay VAT. Thus a foreign company operating a website providing advertising and middleman services for Israelis must pay VAT on revenues from Israeli customers.