Dr. Avi Nov, Adv.
The first stage is to determine whether the royalties are from Israeli sources and, therefore, subject to Israeli taxation under the Israel U.S income tax treaty.
Under Article 6 (General Rules of Taxation) of the Israel U.S tax treaty, one Contracting State may tax a resident of the other Contracting State only on income from sources within the first-mentioned Contracting State (provided, with certain exceptions that the resident is not a citizen of the first-mentioned Contracting State).
Under Article 14 of the Israel U.S. Tax Treaty, royalties derived by a resident of one of the Contracting States from sources within the other Contracting State may be taxed by both Contracting States, but shall not be taxed by the other Contracting State at a rate in excess of 10 percent of the gross amount of a copyright or film royalty or at a rate in excess of 15 percent of the gross amount of an industrial royalty.
However, under Article 4(3) of the Israel U.S tax treaty, royalty income derived from intangibles is sourced in the ‘place-of-use’ of such intangibles. The place-of-use standard in Article 4(3) is modeled upon the ‘place-of-use’ language of Section 861(a)(4) of the U.S. Internal Revenue Code and, therefore, should be interpreted in conformity with U.S. tax law.
Under U.S. domestic law (Section 861(a)(4)), the ‘place-of-use’ of a copyright – and, thus, the source of the royalties derived from a copyright – is the country from where the product is distributed under the protection of copyright law, i.e., distributed to the end user.
Therefore, if an Israeli company pays royalties to a US company for certain software, but distributes the product outside Israel, no Israeli withholding tax should be imposed on the royalties paid by the Israeli company because the royalties would not be of Israeli source.
The fact that the copying of such software (or other process) takes place in Israel does not make Israel a “place-of-use” of the copyright and, therefore, should have no impact on the source of the royalty income. Rather, the place of distribution of the software is what determines the source of the royalties.
Double taxation would result if (i) the “place of use” of the copyright were determined to be outside of Israel (for example, if the software were to be distributed to end-users outside of Israel), and (ii) the Israeli tax authorities nonetheless required that tax be withheld.
In such case, the Israeli tax would not be creditable against the U.S. income tax liability because U.S. law allows foreign tax credits only with respect to U.S. tax attributable to non-U.S.-source income, withheld in accordance with the provisions of an applicable tax treaty. As a result, the royalties would be taxed both in Israel and the United States, subject to the competent authorities establishing a common source of the income.