Honor thy tax treaty

The District Court has just ruled that an Israeli resident taxpayer cannot credit foreign tax voluntarily paid in excess of the tax rate prescribed in a tax treaty. This may sound simple, but was the tax really excess and was it really paid voluntarily? (FK Generators and Equipment Ltd v Holon Assessing Officer, 45306-02-17). This case is like an iceberg with many big issues below the surface that are relevant to Israeli exporters and others.

The case judgment was issued in two parts on December 16 last year and July 12 this year.

The main facts

An Israeli company leased some equipment to its Brazilian subsidiary in 20102012. The paying bank in Brazil withheld 15% tax at source from the lease payments pursuant to domestic Brazilian law, and remitted this tax to the Brazilian Federal Tax Revenue Authority (RFB in Portuguese). The problem is that only 10% tax should have been withheld under Section 12 of the Israel-Brazil tax treaty (“the Treaty”). The Israeli Brazilian companies were apparently unwilling to apply to the RFB for a refund of the 5% difference in case the RFB claimed the Israeli company had a permanent establishment (PE) under the Treaty in Brazil, which would have resulted in 34% Brazilian corporate income tax on the profit thereon.

The Israeli company obtained legal advice and opinions stating that the PE tax risk existed. Rather than approach the Brazilian RFB itself, the Israeli company asked the Israeli Tax Authority (ITA) to approach the Brazilian RFB for a refund of the 5% excess tax withholding and deal with any PE issues the RFB may raise. This was under the mutual agreement procedure in Article 26 of the Treaty.

The ITA refused to do so, claiming there was no dispute. The ITA did apparently email the RFB and received a general reply agreeing there was agreement that the Treaty was applicable.

The Israeli company still hesitated and did not approach the RFB for a refund of the 5% tax difference in case it ended up with a PE problem, so the ITA only allowed a credit for 10% withholding tax not 15%. The District Court was asked to resolve the stalemate.

First judgment

The court ruled that the Israeli taxpayer company lost its ability to raise the PE (permanent establishment) issue on technical grounds, because it did not do so in time – by the assessment appeal stage. Actually the taxpayer mentioned the Brazilian PE issue as a potential concern if it were to approach the RFB, but that was not enough because it didn’t approach the RFB. Also, the profit of any such PE and tax thereon (34%) was never calculated. And the lack of dispute between the ITA and RFB meant the ITA could not be ordered by the Court to undertake the mutual agreement procedure.

Second judgment

The Court ruled the Israeli taxpayer company could not credit the foreign tax paid (15%) because tax treaties override domestic Israeli legislation (ITO Sec. 196), so only the 10% treaty tax rate should be credited. This is because tax treaties are not only intended to avoid double taxation but also allocate equitably tax revenues between the countries that are party to the treaty.

“It is not the taxpayer that determines the tax allocation, but the countries, and a taxpayer cannot decide by itself that he prefers to pay more tax to one country than another contrary to the treaty.” Also “the taxpayer should check, from the outset regrettably, that tax is collected according to the treaty or bear the consequences. The court ruled that the taxpayer chose to refrain from the “trivial act” of asking the Brazilian RFB for a tax refund and should suffer the results of its failure.

Comments

The Brazilian RFB may be considered to be a tough tax administration. The presence of substantial equipment may trigger PE taxation in Israel and elsewhere, according to ITA practice, the OECD model tax treaty commentary, and after six months according to the US-Israel tax treaty. But the Brazil-Israel tax treaty is less clear on whether substantial equipment triggers a PE and we don’t have the full facts.

Should the ITA have come to the Israeli taxpayer’s rescue by initiating the mutual agreement procedure in the Israel-Brazil treaty? The court referred to page 1,897 of the full OECD model tax treaty commentary without quoting it. It says that a continuous high degree of coordination is needed between States.

As always, consult experienced tax advisers in each country at an early stage in specific cases.