The Israeli Tax Authority on Treaty Shopping

Beneficial Owner|Withholding Tax| Tax Treaties

Dr. Avi Nov, Adv.

January 2010

The Israeli tax authority position on Treaty Shopping can be found in a Circular entitled “Counteracting Tax Planning Based on Treaties for the Avoidance of Double Taxation” (Circular number 3/2001). To date, Israel has signed tax treaties with about 50 countries.

 

Treaty Shopping is said to exist if a resident of a particular country takes steps to establish an entity such as a company in another country, with the aim of obtaining entitlement to benefits or reliefs under its law and tax treaties that the other country is party to, such as:

  • reduced withholding tax on dividends leaving Israel
  • reduced withholding tax on royalty payments exiting Israel
  • reduced tax upon repatriating income to Israel

The position of the Israeli tax authorities is that improper exploitation of the treaties (“treaty abuse”) occurs in cases of:

  • use of tax treaties to obtain tax relief or benefits in a way not intended by the drafters (not defined) of the treaty
  • performance of an act without substantial economic rationale.

According to the Circular, methods that may be employed by the Israeli tax authorities for dealing with Treaty Shopping include the following:

1. Check the residency of a treaty country resident seeking treaty benefits - perhaps by inquiry to the foreign tax authority. A resident of a country is generally assessable in that country on his worldwide income.

2. Check the control and management: subject to any treaty, a body of persons will be considered to be resident in Israel if its business is controlled and managed in Israel.

See also: New Israeli Case on Control and Management

3. Use of “limitation of benefits” (LOB) clauses found in some of Israel’s tax treaties to deny treaty benefits in applicable instances - the terms of such LOB clauses vary from treaty to treaty.

4. Identifying the “beneficial owner” of an item of income: some of Israel’s tax treaties make eligibility to treaty benefits conditional on the recipient of income being the beneficial owner of such income.

5. Reliance on general rules of interpretation:. Under Article 31of the Vienna Convention on the Law of Treaties, 1969, a treaty must be interpreted in good faith in the light of its object and purpose. The Circular cites the United States case of Aiken Industries Inc. V. Commissioner of Internal Revenue: a company resident in a treaty country was used merely to relay interest income to a company in another country, so a withholding tax exemption in the treaty did not apply to the interest income.

6. Application of domestic anti-avoidance measures: Under Section 196 of the Income Tax Ordinance, the Minister of Finance promulgates Orders that implement treaties for the avoidance of double taxation which take precedence over domestic law. By contrast, the Circular asserts that Section 86 of the Income Tax Ordinance may be invoked by the tax authorities to disregard a transaction or act that is artificial or has improper avoidance or reduction of tax as one of its principal objectives. The Circular state this is similar to the Anglo-American doctrine of “economic substance over form”.

See also: Israel double tax treaties and anti-tax avoidance rules

It seems likely that the Israeli tax authorities may increasingly challenge treaty shopping situations if an entity or transaction is deemed to lack sufficient economic substance. The commercial rationale for entities and transactions should therefore be evident.
 
Dr. Avi Nov Law Offices, Israeli & international tax law 
*This article is intended for informative purposes only and is in no way to be construed as tax advice or a legal opinion
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