On April 2, 2015, the Israeli tax authority ("ITA") published a draft new circular containing new and unprecedented guidelines with respect to the income tax and VAT aspects applicable to foreign enterprises that transact with Israeli customers over the internet ("the Circular" and "Foreign Enterprises", respectively). The Circular, in its current form, wishes to crown Israel as a leader in dealing with the worldwide common corporate and tax structures, which enable major global companies to manage and oversee tax-free business activities in the different countries and provide services to its residents without having a physical presence or actual business on the land such countries.

The purpose of the Circular is to shed light on: (i) the taxation of Foreign Enterprises; (ii) the rules for recognizing the existence of permanent establishments ("PEs") on behalf of such Foreign Enterprises; and (iii) the methods for allocating the profits derived in Israel by the relevant PE. The Circular focuses on Foreign Enterprises that conduct "digital service activities" and manage internet activities as a major component of their business activities ("the Digital Activities")[1]. Furthermore, the Circular caters for situations whereby the relevant PE in Israel is required to register and maintain a VAT file and be liable to pay the required VAT (currently, 18%).

By issuing the Circular, the ITA aims to broaden the scope of cases in which PEs will be deemed established in Israel, by blurring the conditions for establishing PEs as set out in Article 5 of the OECD Model Tax Convention ("the Convention").

Notwithstanding the aforementioned, the Circular distinguishes between Foreign Enterprises which are residents of a treaty state and Foreign Enterprises that are residents of a non-treaty state. It seems likely that the ITA will find it easier to retain more profits of non-treaty state residents. Such distinction should be taken into consideration when planning to engage in business activities in Israel, and particularly Digital Activities.

The Convention provides two alternative options for establishing a PE in a treaty state. According to the first option, a PE will be deemed established wherever the Foreign Enterprise carries on a "fixed place of business". In the case of foreign enterprises engaging in Digital Activities, an interpretation of the Convention seems to place relative importance on the place where the relevant foreign enterprise’s server is physically located, in order to determine the existence of a PE. According to the ITA's approach, as reflected in the Circular, greater significance should be placed on the economic business and financial activity conducted in Israel, even where the Foreign Enterprise’s servers are located abroad and no office or branch exists for such Foreign Enterprise in Israel. The Circular sets out a list of indicators that may give rise to the allegation of the existence of PEs for Foreign Enterprises engaging in substantial Digital Activities. Furthermore, the Circular suggests narrowing the exclusions provided in Article 5(4) of the Convention, should the aforementioned indicators apply to the Foreign Enterprise. Thus, a PE may be deemed established in Israel even if the domestic activity is carried out through, or in collaboration with, other Israeli companies.

As mentioned above, the ITA has not remained apathetic with respect to the second option as suggested in the Convention, pursuant to which a PE will be deemed established whenever there is a dependent person acting in Israel on behalf of the Foreign Enterprise. The Circular appears to suggest a more “trigger-happy” approach in terms of which a third party, or a related Israeli company ("an Agent"), will be deemed the dependent person establishing the PE in Israel, where there exist indicators showing that the Agent has the authority to participate in the negotiation of contracts, even if such contracts will ultimately be executed by the Foreign Enterprise outside Israel. In other words, the authority attributed to the Agent may be sufficient to deem a PE liable to pay tax in Israel.

As aforementioned, the Circular also contains new and precedent-setting guidelines with respect to VAT and the associated reporting duties, including the registration duty for VAT purposes ("the VAT Duties"). Under the Circular, the VAT Duties will be imposed on Foreign Enterprises in respect of their domestic Digital Activities, whenever significant services are provided by them to Israeli customers, and there exists "direct and close connections" between the rendered services and Israel. The Circular also contains examples of indicators demonstrating the existence of such "direct and close connections". Needless to say, whenever a PE exists for Israeli tax purposes, the enterprise will be subject to the corresponding VAT Duties.

Perhaps the loudness of the bomb that the ITA dropped by issuance of the Circular reached its highest pitch by means of the examples provided by the ITA for activities that will indeed be subject to VAT. The two examples provided in the Circular concern a Foreign Enterprise that manages a search engine and provides marketing services to Israeli clients among Israeli users of the search engine, and a Foreign Enterprise that provides intermediation services between Israeli hotels and Israeli consumers.

Regardless of the format and wording of the final version of the Circular that will be published and its provisions implemented by the ITA, it is already obvious that the Israeli taxation of Foreign Enterprises that carry out activities in Israel over the internet, including Digital Activities, will undergo unprecedented change that may very well alter the balance of power on the domestic scale in Israel.