Tax Treaties – By Yariv Moyal, Attorney   

What Are Tax Treaties?

Tax treaties are international agreements signed between two countries (bilateral treaties) or more (multilateral treaties) to prevent double taxation, establish cooperation mechanisms between tax authorities, and create legal certainty regarding taxpayers’ tax liabilities across different jurisdictions. The importance of tax treaties has grown in the era of globalization, where companies and individuals conduct cross-border activities in various sectors. These agreements aim to balance each country’s right to tax income generated within its territory with the need to avoid double taxation, which could hinder investments and international trade.

Typically, tax treaties are based on the OECD Model Convention (Organization for Economic Co-operation and Development) or the UN Model, including provisions that define key terms (such as “resident” and “income”), determine tax allocation rights between countries, regulate permanent establishment, withholding tax mechanisms, dispute resolution procedures, and more. When Israel signs a tax treaty with another country, it becomes part of Israel’s tax law, subject to parliamentary approval and official publication.

The Multilateral Instrument (MLI)

General Background

Following the BEPS (Base Erosion and Profit Shifting) project led by the OECD and G20, which aimed to curb aggressive tax planning by multinational corporations, an innovative legal tool was introduced to facilitate the simultaneous update of multiple existing bilateral tax treaties. This tool is known as the Multilateral Instrument (MLI). The MLI enables signatory states to amend and modernize their bilateral tax treaties without renegotiating each one individually.

Israel joined the MLI in 2017, and has since implemented adjustments in its domestic laws and bilateral tax treaties in accordance with the MLI provisions. These changes include updates to the definition of permanent establishment, the introduction of anti-abuse clauses, the expansion of information exchange between tax authorities, and the implementation of dispute resolution mechanisms to address conflicts between countries.

Objectives of the MLI

1. Updating and Modernizing Tax Treaties: Instead of renegotiating each tax treaty separately, the MLI allows signatory countries to apply updates and modern provisions across all existing treaties.
2. Preventing Treaty Abuse: The MLI introduces anti-tax avoidance provisions, such as the Principal Purpose Test (PPT), which aims to determine whether a transaction’s primary objective is to obtain tax benefits under a treaty.
3. Enhancing Legal Certainty and Dispute Resolution: The agreement provides improved mechanisms for resolving disputes between states, including mandatory arbitration on certain tax matters.
4. Expanding the Definition of Permanent Establishment: The MLI refines the concept of permanent establishment to prevent multinational corporations from structuring their business activities in ways that allow them to avoid tax obligations in certain jurisdictions.

Permanent Establishment (PE)

Definition and Significance

The concept of permanent establishment (PE) plays a central role in international taxation. It determines whether a foreign company’s activities in a given country have reached a level that justifies taxation of its income within that jurisdiction. Generally, a PE is defined as a fixed place of business through which the enterprise carries out its business, wholly or partially. However, different types of PEs exist, including:

• Fixed Office/Branch: A physical location where the company manages a significant part of its business.
• Construction Site/Project: A project lasting beyond a certain threshold (e.g., 6 or 12 months, depending on the treaty).
• Dependent Agent PE: An individual or entity that acts on behalf of the company and has authority to sign contracts on its behalf.

The MLI refines the traditional PE definitions to close previous loopholes. For example, it addresses fragmented business activities (splitting contracts to avoid the minimum duration threshold) and restricts the use of agents disguised as “independent” but who are, in reality, dependent on the foreign entity.

Importance for Business Owners and Corporations

1. Increased Tax Liabilities: If a foreign company is deemed to have a permanent establishment, it may be subject to tax obligations on its local income.
2. Enhanced Transparency and Reporting Requirements: The broader PE definition means that more business activities may qualify as taxable, requiring companies to register, report, and pay taxes accordingly.
3. International Tax Planning: Companies must carefully plan their tax strategies to comply with new MLI provisions and avoid unnecessary tax exposure.
4. Avoiding Legal Disputes: Identifying permanent establishment risks early and applying tax treaty provisions can prevent tax disputes with Israeli or foreign tax authorities.

Withholding Tax (WHT)

Background and Meaning

Withholding tax is a mechanism where a taxpayer (e.g., an income payer) is legally required to deduct tax at the source before transferring payment to the recipient and remit the tax to the local tax authority. This system ensures efficient tax collection and prevents income from escaping taxation due to enforcement challenges against foreign taxpayers.

In an international tax context, withholding tax is commonly applied to payments such as royalties, interest, and dividends made to foreign entities. Tax treaties define maximum withholding tax rates and sometimes offer reductions or exemptions based on the income type and the recipient’s residency.

MLI and Withholding Tax

The MLI also tackles withholding tax planning strategies. For example, the PPT clause prevents treaty shopping, where multinational corporations route transactions through jurisdictions with favorable withholding tax rates solely for tax benefits. Additionally, the MLI improves tax information exchange mechanisms, allowing tax authorities to track cross-border payments more effectively.

Key Considerations for Lawyers and Tax Advisors

1. Applying Treaty-Based Tax Rates: It is crucial to verify whether the counterparty’s country has ratified the MLI and to assess which provisions apply. This helps determine reduced withholding tax rates or applicable exemptions.
2. Submitting Withholding Tax Relief Forms: In many cases, businesses need to submit residency certificates (such as Form 6166 in the U.S. or the Israeli equivalent) to claim treaty benefits.
3. Transaction Legitimacy: Legal professionals must ensure that transactions are legitimate and do not involve treaty shopping. Under the PPT rule, tax benefits may be denied if a business structure is deemed artificial.

The Significance of the MLI for Israel

For Israel, joining the MLI aligns with its commitment to OECD standards and enhances its appeal to foreign investors. While increasing transparency, it also places additional responsibilities on Israeli tax authorities to monitor treaty compliance and enforce new provisions properly.

Israeli lawyers, accountants, and tax advisors face new challenges in guiding foreign companies operating in Israel, as well as Israeli companies expanding abroad. The risk of creating a permanent establishment in Israel has increased, and withholding tax rates may be higher if treaty benefits do not apply.

Challenges in Interpretation and Implementation

The MLI allows countries flexibility in deciding which provisions to adopt (Opt-in/Opt-out system). As a result, despite being a multilateral agreement, its implementation varies significantly between jurisdictions. Legal and tax professionals must analyze each country’s MLI position to ensure compliance across different territories.

Moreover, MLI provisions require a review of prior agreements, assessment of business practices, and attention to fine details that could lead to unexpected tax liabilities. For example, an agent disguised as an independent contractor may still create a permanent establishment, and structuring contracts in short-term segments to circumvent PE thresholds may no longer be effective due to anti-fragmentation rules.

Legal Disclaimer

This article is for informational purposes only and does not constitute legal advice, a legal opinion, or a recommendation for action. It should not be relied upon as a substitute for specific legal consultation tailored to individual circumstances. Reading this article does not create an attorney-client relationship, and the author or law firm is not liable for any damages resulting from reliance on this information. For legal advice, consult a qualified attorney.