An Israeli company pays a foreign supplier every month for access to a cloud platform. No software is downloaded, no source code changes hands, no copy passes to the company, and there is no right to reproduce, distribute or modify. There is a connection to the supplier’s server and use of functionality. The question is whether a duty to withhold tax at source arises on the payment.

If it does and nothing was withheld, the assessing officer may raise a withholding assessment for failure to withhold on a payment to a foreign resident. Since the tax cannot in practice be passed back to the foreign supplier, it falls on the paying company.

Where the duty to withhold comes from

The duty sits in section 170 of the Income Tax Ordinance and in the Income Tax Regulations (Withholding from Payments to a Foreign Resident), 5753-1992. The default rate under section 170(a) is 25% for an individual and the corporate rate, 23%, for a body of persons, unless the assessing officer has directed otherwise or a treaty sets a reduced rate. Across Israel’s treaties the withholding rate on royalties runs between zero and fifteen per cent.

The duty depends on the income being produced in Israel, and that is where the matter is decided. Section 4A(a)(7) of the Ordinance provides that for earnings or profit, royalties included, sourced in an intangible asset, the place of production is the payer’s place of residence. Where the payer is an Israeli resident the income is produced in Israel and the duty to withhold arises. Section 4A(a)(1), which covers business income, points instead to the place where the income-producing business activity is carried on, and section 4A(a)(3) points, for a vocation, to the place where the service is performed. Activity carried on wholly outside Israel is not produced in Israel.

The classification question is therefore a question of which source rule applies, and not of rate alone.

Two possible classifications

In the OECD Model, article 12 gives the residence state an exclusive taxing right, meaning zero at source. Most of Israel’s treaties depart from that and give the source state a taxing right capped at the treaty rate. Article 7 covers business profits and gives the source state a taxing right only where the supplier has a permanent establishment there.

The choice between the two articles decides the outcome: if the payment falls under article 12 the duty to withhold arises, and if it falls under article 7 with no permanent establishment in Israel, the default is zero.

Exploiting the copyright against using the work

The basic distinction in copyright law is between use of the copyright itself and use of the protected work. The bundle of exclusive rights in section 11 of the Copyright Law, 5768-2007, covers copying, publication, public performance, broadcasting, making the work available to the public, making a derivative work and rental. Performing one of these, meaning exploiting the right, is what creates a royalty. Someone who does not copy, distribute or modify makes no use of the copyright, even while enjoying the protected work.

A SaaS customer performs none of these acts. The only copying that occurs is temporary storage in memory and in network transmission, and section 26 of the Law expressly permits temporary copying that forms an integral part of a technological process. The same distinction appears in the OECD Commentary on article 12, where paragraph 14 provides that rights limited to what is necessary to enable the user to operate the program are dealt with as commercial income under article 7.

The working test is therefore whether the customer exploits the intellectual property commercially or only consumes the output. A company taking a licence to build a derivative product on the intellectual property and sell it, or a licence to market under a private label, is paying for exploitation of the right. A company that subscribes to a service and uses it as it stands falls outside the definition.

The three categories of Circular 13/2001

The central administrative document in Israel on this question is Income Tax Circular 13/2001, “Classification of income from international transactions involving software”, published on 27 December 2001 and applying from 1 January 2002. It classifies three kinds of software transaction, and expressly excludes from its scope, in its opening paragraph, further elements such as the provision of services.

Why a cloud transaction fits none of them

The customer does not acquire the copyright, so the first category does not apply. It receives no copy, so the second does not apply either. It receives no bundle of copyright rights, being barred from copying, distributing or modifying, so the third does not apply. The provision of services was expressly taken out of the circular.

The circular was written in 2001, when the software as a service model did not yet exist in its present form, and it says nothing about a situation in which the customer receives no copy at all and reaches the service through an interface.

The Tax Authority acknowledged this in Circular 9/2017, which deals with the Encouragement of Capital Investments Law and states: “including where no licence is granted at all but access to the software is provided by way of cloud computing over the internet”. That circular does not deal with withholding, but the statement matters here: where no licence is granted, it is hard to see the payment as consideration for a right to use the copyright.

Tax Ruling 4668/20 points the same way. There a company supplying platform services was recognised as a preferred technological enterprise. The ruling confined that recognition to customers acquiring a right to use the software alongside the cloud services, while income from cloud services alone bore ordinary corporate tax. Even within those limits it shows the Authority treating the operation of the platform as technological activity of the supplier.

Three tests that point towards a service

A structural point sits alongside these. A royalty flows from ownership of an intangible asset and is passive in character. In a cloud transaction the income flows from active operation of the servers, ongoing maintenance and updating of the algorithms at the supplier. The person deriving the income from the intellectual property is the foreign supplier, through activity of its own.

Mixed transactions

A single contract may combine access to a service with the grant of a right in the intellectual property. Paragraph 17 of the OECD Commentary on article 12 directs that the total consideration be broken down between the elements by a reasonable apportionment, and Circular 13/2001 has a dedicated section on complex software transactions. Apportionment is not automatic, and where one element is principal and the rest ancillary to it, classifying the whole transaction by the principal element is the more likely result.

What happens when nothing was withheld

A withholding assessment does not stop at the headline rate. Once the charge arises the Authority grosses the payment up, because the payer bearing the tax in place of the supplier is itself a benefit. On a payment of 100 net at a withholding rate of 15%, the charge is 17.6 and not 15.

Alongside the gross-up the Authority applies, there is contractual gross-up. Foreign suppliers with bargaining power contract on a net basis and insert a gross-up clause passing any withholding to the Israeli payer. Such a clause defeats the source state’s ability to place the burden on the foreign supplier: a charge as a royalty does not touch the supplier, and is funded in practice by the Israeli customer.

The two directions of the Authority’s position

Income Tax Circular 4/2016, dated 11 April 2016, deals with the activity of foreign corporations in Israel over the internet and seeks to widen the concept of a permanent establishment so as to tax digital activity carried on without physical presence. In the opposite direction, in the royalty position, the Authority seeks to withhold at source on payments leaving Israel for a foreign cloud supplier. In one direction the value is created at the foreign supplier; in the other the centre of value creation is in Israel.

For a resident of a treaty state the circular is bound by the treaty definition of a permanent establishment, since a treaty prevails over domestic law under section 196 of the Ordinance. The circular seeks to stretch that definition, arguing that activity once treated as preparatory or auxiliary may now be principal. The position is contested.

Artificial intelligence tools

An Israeli company subscribing to an artificial intelligence tool pays a monthly fee for remote access. No software is downloaded, there is no copy of the code and no right to copy, distribute or modify. It sends a request and receives an output.

An attempt to classify such a transaction under Circular 13/2001 fails across all three categories: no copyright is granted, no copy is sold and no bundle of rights is conferred. Services were expressly taken out of the circular.

How the analysis applies

The table applies the tests set out above and does not represent a position of the Tax Authority, which has published no determination on the question.

What is worth doing

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Last updated: 5 September 2026

The content of this page is general information only. It does not constitute legal or tax advice and should not be relied upon in making decisions. The law, the circulars and the rates change from time to time.