Israel's Tax Authority issues new tax ruling on operations held by ...

28 March 2013
Global
<strong>Tax</strong> Alert
Israel’s <strong>Tax</strong> <strong>Authority</strong>
<strong>issues</strong> <strong>new</strong> <strong>tax</strong> <strong>ruling</strong> on
operations held by overseas
companies outside Israeli
territorial waters
Executive summary
The Israeli <strong>Tax</strong> <strong>Authority</strong> (ITA) has issued <strong>Tax</strong> Ruling 8679/13 (Ruling)
holding that drilling services provided by an overseas supplier (Applicant)
in the Israeli Exclusive Economic Zone (EEZ), outside the territorial
waters, is subject to <strong>tax</strong> in Israel. The ITA also ruled that the maintenance
of industrial equipment — the drilling rig — for a period of more than six
months constitutes a permanent establishment in Israel for its treaty
country (US) resident owners. In addition, the <strong>ruling</strong> provides that the
mere fact that a third party HR Company seconded employees to the
drilling project constitutes an Israeli permanent establishment of the
foreign HR Company (even in the absence of any other business presence
in Israel). Finally, the ITA ruled that non-Israeli resident companies are
obliged to withhold Israeli <strong>tax</strong> at source from service fees and salaries paid
to other non-Israeli residents outside the Israeli territorial waters.
Background
Under the facts of the Ruling, Applicant was a foreign company, <strong>tax</strong>
resident in a treaty country, which was engaged by an Israeli company
for the provision of drilling services. The services (the Project) are to be
carried out offshore Israel, in the exclusive economic zone (EEZ) beyond
the Israeli territorial waters (12 nm). Applicant set up an office in Israel and
hired a few Israeli and foreign personnel in order to support the offshore
drilling operations. The Project should last for more than 183 days.

As described in the Ruling, the
Project includes the shipment of a
drilling rig into the Israeli EEZ. The
rig is leased by Applicant from one
of its overseas affiliates (the Lessor)
in an arm’s length triple net lease
agreement. The Lessor is resident
in a treaty country. Although
all references to the treaty and
other country are redacted, the
description of the treaty and its
articles at issue strongly imply
that the Lessor is a resident of the
United States for treaty purposes.
It is also mentioned in the Ruling
that the Project will be carried
out by a majority of non-Israeli
employees who will stay on the
rig outside the territorial waters.
Some of these employees will
be seconded by an unrelated HR
company which is resident in a
country with which Israel has a
<strong>tax</strong> treaty. The remainder will be
seconded by Applicant’s overseas
affiliates. Both the HR Company
and the overseas affiliates will
on-charge Applicant for the HR
services, based on arm’s length
principles.
Applicant approached the ITA
in order to seek certainty with
respect to the anticipated Israeli <strong>tax</strong>
implications for its operations in the
Israeli EEZ.
Discussion
The ITA concluded that the
drilling services to be carried out
by Applicant in the EEZ and its
office in Israel constitute an Israeli
permanent establishment for
Applicant. Accordingly the income
attributed to the PE from the
project (including income derived
from the shipment of the rig from
site to site in the EEZ) is subject
to <strong>tax</strong> in Israel. Moreover, the ITA
concluded that based on the facts
and circumstances of the case,
the (US) Lessor has a permanent
establishment in Israel even though
the leasing agreement provides
that Applicant is held solely
responsible for the operations
and the maintenance of the rig.
This conclusion contradicts the
decision in <strong>Tax</strong> Ruling 1547/10
according to which the mere leasing
of a rig by a treaty country lessor
does not constitute permanent
establishment in Israel. The ITA
justified its recent conclusion
by references to the Permanent
Establishment article of the (US)
treaty, which provides that the
term “permanent establishment”
includes the maintenance of
substantial equipment or machinery
within a Contracting State for a
period of more than six months.
Again, although it is not stated
in the Ruling, it appears that the
Lessor is a US corporation.
In addition the ITA concluded that
the HR Company and any other
overseas company which seconded
employees to the project have a
permanent establishment in Israel.
As a result, the Ruling provides
that Applicant has to withhold
<strong>tax</strong> at source from its grossed-up
payments to these companies as
long as they do not register and file
<strong>tax</strong> returns in Israel.
Global <strong>Tax</strong> Alert
The ITA also concluded that any
foreign employee who works for
the benefit of Applicant is liable to
individual <strong>tax</strong>ation in Israel, even if
the length of their stay in the Israeli
EEZ lasted for less than 183 days.
Finally, the ITA ruled that non-
Israeli resident companies (e.g., the
Applicant and the HR Company)
are obliged to withhold Israeli <strong>tax</strong>
at source from their payments to
other non-Israeli residents (e.g.,
subcontractors or employees) for
services (and salaries) provided in
the rig outside the Israeli territorial
waters. In order to comply with
this withholding <strong>tax</strong> obligation, the
non-Israeli resident companies (the
payers) would have to register with
the Israeli <strong>tax</strong> administration and
open withholding files.
Implications
It is worth noting that Israeli
domestic <strong>tax</strong> law has never annexed
the EEZ or the continental shelf to
Israel. Specific legislation regulates
the oil and gas exploration and
exploitation operations. However, in
practice the ITA takes the view that
the whole EEZ area (up to 200 nm)
is part of the <strong>tax</strong> territory of Israel.
<strong>Tax</strong>payers operating in the Israeli
EEZ should carefully analyze
current structures to assess the
potential impact of the Ruling.
In addition, US <strong>tax</strong>payers that
maintain substantial equipment
within Israel should review the
impact of the <strong>new</strong> Ruling and
consider alternative structures.
2

For additional information with respect to this Alert, please contact the
following:
Kost Forer Gabbay & Kasierer, Tel Aviv
• Sharon Shulman +972 3 5687485 sharon.shulman@il.ey.com
Ernst & Young LLP, Israeli <strong>Tax</strong> Desk, New York
• Ram Gargir +1 212 773 1984 ram.gargir@ey.com
3 Global <strong>Tax</strong> Alert
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