Dr. Avi Nov, Adv.

September 2010

The purpose of source rules is to determine the place of income accrual. The importance of these rules for residents of Israel is mainly the issue of credit for foreign tax. As for foreign residents and foreign corporation, the importance of source rules is mainly in determining the right for taxation in Israel.

The income of a foreign resident or foreign corporation will be taxed in Israel only if accrued in Israel. Articles 4A and 89(B)(3) of the Israeli Tax Ordinance establish the place of accrual of the various incomes.

A. Yield incomes

Article 4A(A) determines the place of accrual for yield incomes, as follows:

Concerning income from a business - the place where the business activity yielding the income takes place.

Concerning income from a transaction or an incidental business of a commercial character - the place where the transaction or businessl take place.

Concerning income from vocation - the place where the service is performed.

Concerning income from employment - the place where the work is performed.

Concerning interest, discount fees and linkage differentials - the payer’s place of residence.

Concerning rent or property usage fees - the place where the asset is used.

Concerning wages or profits, including royalties, originating from an intangible asset - the place of residence of the payer.

On this source rule, see:

• Israeli Taxation of Computer Software: The Tax Authority Position
• Deduction of tax at source from payments to foreign residents
• Withholding Tax Rates in Israel's Tax Treaties

Concerning pension, usufruct or annuity - the place of residence of the payer.

Concerning income from agriculture - the place of the asset yielding the income.

Concerning dividends - the place of residence of the body of persons paying the dividends.

Exceptions to the source rules

Article 4A(B) of the Amendment establishes a number of exceptions concerning the place of accrual of incomes as elaborated below:

Employment income

The rule concerning the place of accrual of income from work is the place of execution of the work. Therefore, the place of income from work performed outside of Israel is not in Israel. However, if the employer is one of the bodies specified below and the working relations with that employer commenced while the employee was a resident of Israel, the place of generation of the income will be considered to be Israel, despite the work having been performed outside of Israel.

The bodies for which this exception applies are listed in Paragraph (A)(4) of the definition of an “Israel resident”: the State of Israel, a local authority, the Jewish Agency, the Jewish National Fund, Keren Hayesod, the United Jewish Appeal, a government company, a government authority or a corporation founded by law.

Expense of a permanent enterprise

This exception relates to the situation where a permanent establishment of foreign residents in Israel or of Israeli residents outside of Israel, has an expenditure for which the source rule is the place of residency of the payer– interest, discount fees and linkage differentials, profits and royalties originating from an intangible asset, pension, usufruct or annuity.

This rule determines that income from these sources will be considered generated in Israel even when the payer is a foreign resident – if the payment constitutes an expense of the permanent establishment of an overseas resident in Israel, or alternatively – income from these sources is considered as generated outside of Israel even when the payer is a resident of Israel – if the payment constitutes an expense of his permanent establishment in Israel.

In these cases, a criterion of the location of the permanent establishment is effectively opted for rather than the place of residency. For example: a foreign resident who has activity in Israel through a permanent establishment. This activity is funded by foreign capital, therefore interest expenses are deductible in Israel.

In such a case, it has been established that despite the payer being a foreign resident, the place of generation of the interest income is in Israel (the location of the permanent establishment).

B. Capital income

Article 89(B)(3) establishes that the place of accrual or derivation of capital profit will be in Israel in each of the following cases:

A. The asset sold is in located in Israel.

B. The asset sold is located outside of Israel and is mainly a right, directly or indirectly, for purchase (including securities, real estate and rights in a real estate association) located in Israel. Concerning such an asset, the part of the consideration arising from the asset located in Israel shall be considered capital profit accrued in Israel.

C. A share or right to a share of a body of persons residing in Israel.

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