The World Tax Advisor - July/August 2005 (Recent Developments in the Middle East)

• Parliament Passes Multi- Year Reform in First Reading
• Court Issues Ruling on MAP in Tax Treaties

A joint committee set up by the State Revenue Administration and the tax authorities recently issued its recommendations for a multi-year program that would continue the tax reform that began in 2003. A bill embodying the proposals was introduced in the Israeli Parliament on 4 July and passed in its first reading on 11 July. The proposal was then forwarded for discussion to the finance committee for possible changes. Once passed, the proposed measures are expected to go into effect on 1 January 2006. The discussion below reflects the joint committee's (Committee's) recommendations.

The Committee recommends that both the corporate tax rate and the individual income tax rate gradually be reduced over a four-year period. The corporate rate would go down to 25% by 2010 (31% in 2006, 29% in 2007, 27% in 2008 and 26% in 2009). Beginning in 2006, individual income tax rates also gradually would be reduced, reaching a maximum marginal rate of 44% by 2010 (49% in 2006, 47% in 2007 and 46% in 2009).

To encourage the creation of international management centers, the Committee proposes the introduction of a special tax regime for Israeli holding companies investing in foreign corporations. Qualifying companies would be entitled to a participation exemption for dividends received from foreign subsidiaries and capital gains derived from the sale of shares in foreign subsidiaries, and would be exempt from tax on financial income derived from investments in the Israeli capital market. The withholding tax on dividends paid by the Israeli holding company to nonresidents would be limited to 5% (instead of the normal 25%).

To be considered a "holding company," a private company incorporated and managed in Israel would have to satisfy certain conditions, the most important being a minimum investment of NIS 50 million in shares and loans of foreign subsidiaries that are resident in countries that have concluded a tax treaty with Israel. Additionally, the primary source of income of the holding company (i.e. 75%) would need to consist of business income generated abroad. The tax rate imposed on the income of the foreign subsidiaries could not be lower than 15%.

The Committee also made a number of recommendations relating to the taxation of passive income. Companies would be subject to tax on dividends (excluding dividends received from an Israeli corporation), interest and capital gains at the rate applicable to corporate tax. However, during the period 2006-2009 (when the corporate tax rate exceeds 25%), the gradual reduction in the tax rates described above would not apply in respect of dividends and capital gains, which would be subject to a 25% tax rate.

For individuals, the Committee recommends the imposition of a 20% tax on dividends, interest and capital gains. A controlling shareholder would be subject to a 25% tax on dividends received from a company controlled by him (including an imputed dividend received from a controlled foreign corporation and on "real" capital gains derived from the sale of securities issued by the individual’s controlled company (including a land association or a company whose major assets consist of real estate located abroad). Interest received by an individual from his controlled company would be subject to tax based on the individual’s applicable marginal tax rate.

The Committee also recommended a temporary tax exemption for capital gains derived by nonresident companies and individuals on the sale of securities issued by Israeli companies provided the nonresident resides in a country that has concluded a tax treaty with Israel. The exemption would be available from July 2005 to the end of 2008.

On 7 April 2005, the Israeli District Court ruled, in Jeteck Technologies Ltd. v. Assessing Officer K’far Saba, that tax appeal proceedings should be suspended pending completion of the mutual agreement procedure (MAP) provided for in article 25 of the Israel-Japan tax treaty. The decision provides important guidance on the place the MAP holds in the overall tax assessment process in Israel.

The case involves Jeteck Technologies, a company engaged in the development and production of software designed for end-users. In 1997, Jeteck entered into an agreement with a Japanese company (JC), according to which it granted JC the right to use Jeteck’s software products in World Tax Advisor 2 of 4 July/August 2005 exchange for royalty payments. Product support and maintenance services were bundled in with the software agreement, but Jeteck did not charge for these services.

The Japanese tax authorities classified all of JC’s payments to Jeteck as royalties, so JC withheld tax at source at a rate of 10% in accordance with the treaty. During the tax assessment process, Jeteck claimed a tax credit equal to the amount withheld in Japan. The Israeli assessing officer rejected Jeteck’s claim on the grounds that Jeteck failed to demonstrate which portion of the payments related to the right to use the software (i.e. the portion of the payments that should be classified as royalties and subject to withholding tax) and which portion was attributable to support and maintenance services (i.e. the portion of the payments that should be classified as business income and not taxed in Japan in the absence of a permanent establishment in Japan). The assessing officer classified all of the payments as business income, which is subject to tax exclusively in Israel in accordance with the treaty, and issued an assessment on that basis. The disallowance of the credit for tax withheld in Japan gave rise to double taxation for Jeteck.

Jeteck filed a request with the International Taxation Unit to initiate a MAP with the Japanese tax authorities to settle the dispute arising from the differing classifications of the income. Simultaneously, Jeteck submitted an appeal to the District Court claiming that the assessment based on the Israeli assessing officer’s determination with respect to the classification of the payments from JC was incorrect and would lead to double taxation in Israel. Jeteck also requested that the tax appeal proceedings be suspended until the MAP was completed.

The Israeli tax authorities contended that it was premature to initiate the MAP because no determination had been made by the Court as to whether JC’s payments were royalties subject to withholding tax or services income taxed under the business profits provision in the treaty. Since the appeal process had not concluded, the tax authorities argued that the issues had not "matured" sufficiently to invoke the MAP with the Japanese tax authorities.

The District Court had to determine whether Jeteck had the right to initiate the MAP in the tax treaty before exhausting the domestic tax appeal process.

In its decision, the Court emphasized that it is the role of the tax authorities, not the District Court, to make findings of fact. The Court merely determines whether the tax authorities exercised their discretion in a reasonable manner.

The Court rejected the argument of the tax authorities, concluding that Jeteck has the right to invoke the MAP even though the tax appeal process had not been exhausted. The Court based its conclusion on the purpose of the treaty, which is the prevention of double taxation. That purpose is achieved when the taxpayer has the right to invoke both the domestic tax appeal process and the MAP concurrently, even before conclusion of the assessment (or tax appeal) proceedings. World Tax Advisor 3 of 4 July/August 2005

The Court held that the MAP should be considered a part of the tax assessment process in its overall context; otherwise, the taxpayer would be placed in a severely disadvantaged position. In this context, the Court clarified that, as long as a court decision is not final (i.e. there is still right to appeal) and a final assessment has not been issued, the tax authorities still would be able to negotiate with the Japanese tax authorities and reach a compromise under the MAP. Conversely, if a final decision or final assessment (without any possibility of subsequent amendment) was issued, the Israeli tax authorities would not have the flexibility required for competent authority negotiations with the Japanese authorities.

The District Court’s decision in Jeteck Technologies provides an important clarification by holding that the MAP is considered an integral part of the Israeli tax assessment procedure. As a result, the tax authorities must allow a taxpayer to invoke the MAP even though the issue is being reviewed by the court. A denial by the Israeli tax authorities of a request for a MAP must have a sound and reasonable basis – for example, if a final assessment has been issued. The justification advanced by the tax authorities in this case – i.e. that it was premature to invoke the MAP because the Court had not rendered a final decision on the classification of the income – is not considered reasonable.

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