31/8/07 eu-israel Trade in the Automobile Sector: Is Israel's High Taxation of Cars Legal under the Association Agreement? Arie Reich

In all my courses on International Trade Law or on EU-Israel relations that I have taught over the last sixteen years or so, whenever I reach the subject of the free trade area between Israel and the EC and the guarantee of duty-free treatment of goods, I always have the same experience. When told that all manufactured goods made in the EC and imported into Israel are exempt from custom duties under the Association Agreement, my students will always ask me: "How can you say that? Surely you must know that there is a very high duty of over 100% on all imported cars, including those from the EC!" In view of the importance of cars and the considerable financial burden that their high prices put on practically every Israeli, by posing this question my students are not only asking for information on some of the finer details of the Association Agreement, but are in effect expressing their mistrust in the very essence of my claim about free trade between Israel and the EC (or with any of Israel's other free trade partners). My attempts to explain that cars from the EC are really exempt from custom duties, and are only subject to Purchase Tax and Value Added Tax (VAT) and that the latter do not amount to "charges having equivalent effect" to custom duties since they are imposed on locally-made and imported cares alike, are usually met with laughter. The reason is simple: everybody knows that there is virtually no car manufacturing in Israel, and thus the only ones who pay the high purchase tax are the importers. I usually persist with my thesis claiming that since there is no discrimination involved, and since the purchase tax cannot be claimed to protect the domestic industry, one must conclude that the high purchase tax on cars is perfectly legal under the Association Agreement.

Now, however, I would like to question this proposition. I would like to suggest that perhaps my students' intuitive reaction is the more correct one. Indeed, how can a tax that in practice is imposed only on imports and which by virtue of its extremely high levels clearly has a significant impact on trade volumes, be said to be compatible with free trade? Isn't it an obstacle to the free movement of goods that should have been removed by over thirty years of economic integration between Israel and the EU? In this paper I would like to examine this question both from a legal point of view, mainly in light of case law of the European Court of Justice (the ECJ) and possible interpretations of the existing Association Agreement, as well as from an efficiency perspective. Within the latter perspective we will ask ourselves what the costs and benefits of the current policy are, and whether it is justified from a normative standpoint.
II. Background: Israel's Purchase Tax on Automobiles

Cars that are commercially imported into Israel are subject to several taxes. Cars originating from countries with which Israel has no free trade agreement are subject to a customs duty at the rate of 7% ad valorem. Cars made in and imported from countries which have concluded free trade agreements with Israel (such as the EC, EFTA, USA, Canada, Turkey and Mexico) are not subject to any customs duty. However, they, and all other imported cars, are subject to a purchase tax which until 2005 amounted to 95% on private vehicles and 75% on commercial vehicles. In addition they are subject to VAT, which currently stands at 15.5% (and formerly was as high as 18%), and a port fee of 1.02%. In 2005, the Israeli Government initiated a reform program aimed at reducing the purchase tax on cars and equalizing the rates that apply to private and commercial vehicles. Accordingly, at present (2007) the rate of purchase tax for private vehicles is 84% and for commercial vehicles it is 72%. In 2010, the target date of the reform, the rates for all types of cars are planned to converge at 72%.¹

(2) It hampers the ability of a car owner to change his car to a newer and safer model. Cars in Israel are kept and driven for a longer time than in other developed countries,⁸ and the older car fleet on Israeli roads means less car safety and more air-pollution. A public commission on road safety in Israel, appointed by the Minister of Transportation and headed by the distinguished economist Dr. Jacob Sheinin, found in 2005 that the relatively high age of cars in Israel is one of the reasons for the high accident rate (Sheinin, 2005).⁹ The commission therefore recommended changes in the purchase tax system in order to bring down the average age of cars in Israel and increase their safety. As for air-pollution, according to figures of Israel's Ministry of Environmental Protection, old cars are today the main source of this pollution, much more than their relative portion in the car fleet. This stems from the fact that they were built according to old technologies and as they grow older they pollute even more. For instance, the emission of nitrogen oxides of cars manufactured before 1992 are about seven times higher than cars manufactured after 1992, and the emission of carbon monoxide about five times higher (Ministry of Environmental Protection, 2007).

GDP* for a person, in PPP**

*Gross Domestic Product

Source: Israel's Central Bureau of Statistics; Figures are for 2003.

Customs duties on imports and exports, and any charges having equivalent effect, shall be prohibited between the Community and Israel. This shall also apply to customs duties of a fiscal nature.

Quantitative restrictions on imports and all measures having equivalent effect shall be prohibited between the Community and Israel.

“The Parties shall refrain from any measure or practice of an internal fiscal nature establishing, whether directly or indirectly, discrimination between the products of one Party and like products originating in the territory of the other Party.”

4. 
   Is Israel's Purchase Tax on Automobiles Legal Under the Association Agreement?
   

As we have seen, the EU-Israel Association Agreement aims to reinforce the free trade area between the parties, to expand trade in goods and services and to further integrate Israel's economy into the European economy (Preamble and Article 1 of the Agreement). It aims to achieve free movement of goods between the parties, as is evidenced from the heading of Title II ("Free Movement of Goods"), under which all of the provisions cited above are found. For that purpose, the Agreement requires the elimination of all custom duties and quantitative restrictions on trade between the parties, so that there will be no obstacles to the free flow of industrial goods between Israel and the EC.

However, it is a well known fact in international trade that movement of goods can be obstructed not just by custom duties and quotas, but also by less explicit and more indirect types of trade barriers. While the name of the measures may differ, and sometimes also the manner in which they are imposed and function, their trade distorting effect is often equivalent to that of traditional trade barriers. If such measures were to be allowed, it would be easy to circumvent the agreements and to block imports by all kind of measures with different names. In order to prevent this, international trade agreements therefore often prohibit also all other types of measures if their effect is equivalent to that of custom duties or quotas. That is indeed what the EU-Israel Association Agreement has done in Article 8 and 16.
2. How to Interpret "Charges of Equivalent Effect"?

What exactly is the meaning of "charges having equivalent effect" as referred to in Article 8? Since this term is found also in the EC Treaty (Article 25) and has been subject to many judgments of the European Court of Justice (the "Court"), we can find guidance in these decisions. Of course, the Court does not bind Israel in its decisions, and the judgments in questions were given in relation to the EC Treaty and not the Association Agreement. It is also true, that generally the aim of the EC Treaty - namely, full economic integration between the Member States of the EU into one single common market - is much more ambitious than that of the Association Agreement between Israel and the EU. Considering that according to the Vienna Convention on the Law of Treaties, a treaty "shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose" (Article 31(1)), the somewhat different objects and purposes of the two agreements may therefore sometimes lead to different interpretations of the same terms as they appear in the two treaties. However, in relation to the correct interpretation of the term "charge of equivalent effect" the respective objects and purposes of the treaties are not so much different: both treaties aim to establish a free trade area between their respective parties (it should be noted that such an area is one of the components of the common market established in the EU) and to achieve free movement of goods (as evident from the identical headings in both treaties¹²). Moreover, when the Association Agreement was concluded in 1995 between Israel and the EU, there was already a well-established jurisprudence on the exact meaning and scope of the term "charges of equivalent effect", both by the Court and by other judicial bodies and one can safely assume that both parties were aware of this jurisprudence. Thus, in the absence of any reservation by any of the parties to the contrary, it is reasonable to conclude that when using this term in their agreement the parties intended to adopt it in accordance with its ordinary and well-established meaning.

In Case 77/72 Capolongo v. Maya¹³ the Court held that a "charge having an equivalent effect" includes any tax demanded at the time of, or by reason of, importation and which results in the same restrictive consequences on the free movement of goods as a customs duty by altering the cost price of that product. When such a tax, even if not at a significant rate, is imposed specifically on an imported product, to the exclusion of the similar domestic product, it alters the competitive conditions between these two competing products to the benefit of the domestic product, and it can easily be understood why the Court saw such a tax as having equivalent effect to a customs duty. But when no similar domestic product exists, and the tax cannot be seen as protecting or benefiting the domestic production of such a similar product, can one still consider a tax as having equivalent effect to a customs duty on the mere account of its obstructing the free movement of goods?

This question was addressed by the Court in several cases. In Case 24/68 Commission v. Italy (Re Statistical Levy)¹⁴ the Court held:

"…any pecuniary charge, however small and whatever its designation and mode of application, which is imposed unilaterally on domestic or foreign goods by reason of the fact that they cross a frontier, and which is not a customs duty in a real sense, constitutes a charge of equivalent effect even if it is not imposed for the benefit of the state, is not discriminatory or protective in effect, and if the product on which the charge is imposed is not in competition with any domestic product."

A similar ruling was handed down in Case 2 & 3/69 Sociaal Fonds voor de Diamantarbeiders v. Brachfeld.¹⁵ There the Court held that taxes of equivalent effect include all charges levied on goods solely because they cross the frontier from one state into another, irrespective of the purpose for which the charge is levied. It was also held that in order to breach the prohibition against charges having equivalent effect, the charge need not be introduced for protectionist reason. The case dealt with a Belgian law that required all persons importing uncut diamonds to pay a "contribution" to a social fund for diamond workers. Similar to the situation in our case, there was no local production of uncut diamonds in Belgium. Thus, the charge could not be claimed to grant protection to the domestic manufacturer of such diamonds, and in fact the Court acknowledged that it may have been levied for a most worthy purpose (to provide a social fund for workers in the diamond industry). Nevertheless, the Court found that the contribution amounted to a "charge of equivalent effect" and was thus prohibited under the Treaty. In reaching its decision the Court looked at the effect of the measure and held that any pecuniary charge imposed on goods by reason of the fact that they cross frontiers is an obstacle to the free movement of goods.

While the Court did not explain why this was so, the reason seems to be self-apparent according to simple economic logic: when a product costs more, it will usually be consumed less. The circumstances where demand is completely rigid and unaffected by price are rare, and the higher the tax is, the more unlikely it is that the consumption will remain unaffected. Thus, while this type of tax does not divert consumption from imported goods to domestically produced goods – as most customs duties do – it does reduce consumption as a whole, and hence the volume of imports.

When applying this ruling to our case, we note that the Israeli purchase tax is imposed at the border by reason of the fact that the cars have been imported into Israel. We also note that because of its extremely high rate, the purchase tax has a significant negative impact on the number of cars imported. In other words, if the tax was lowered or eliminated, clearly there would be more cars imported to Israel from the EU. One can therefore conclude that the purchase tax constitutes an obstacle to the free movement of goods between the two countries. This conclusion is also supported by the analysis of Dr. Nellie Munin, Israel's former Minister of Economic Affairs to the EU and a specialist on international trade law.¹⁶

Secondly, the Purchase Tax Law has two different "triggers": one is importation (i.e., goods crossing the frontier) and the other is sale, as provided in Article 2 of the Purchase Tax Law:

"Purchase tax (hereafter – the tax) shall be imposed on the importation and on the sale of goods subject to the tax…" (emphasis added – A.R.)
The Law clearly provides for two different tracks of tax liability. One track applies to imported goods and another one applies to domestically produced goods. Importers cannot postpone payment of the "purchase" tax until the imported goods are purchased by their customers, like their competitors, the local producers, can. The importers, who are subject to the first track of the law, the "import track", must pay the tax first in order to release the goods from the custody of the customs authorities, even if the goods will then lay in stock for several months. In contrast, the local producers, who are subject to the second track of the law, the "sale track", can postpone the payment until 30 days after the month in which the goods were sold to their customers.
There are also many other differences between the "import track" and the "sale track". For instance, under the "sale track" that applies to domestic products, the calculation of the tax is done according to the method set out in Articles 4-4A of the Law, whereas under the "import track" the calculation is done according to a different method, set out in Article 4B of the Law. This provision refers to certain provisions of the Customs Ordinance, which set out the method of customs valuation. In addition, importation is subject to a special system called TAMA, which prescribes a higher basis of tax liability for imported products than the price at the time of importation. This system does not apply to locally made products.

The fact that these are two completely different tracks was acknowledged by Israel's Supreme Court in the matter of Tal-Ron Industries v. Minister of Finance.¹⁸ In that matter the petitioners, importers of car batteries, complained that they were subject to discrimination in relation to the local producers of batteries, because they were subject to the provisions of the Customs Ordinance, whereas the local producers were subject to the provisions of the Purchase Tax Law. Under the former, an importer of batteries who wishes the manufacturer to exchange a defective battery, has only six months to get a refund of the purchase tax, while under the latter a local producer has three years to do the same. To this the Supreme Court responded:

1. 
   Tax Base; For Israeli products the tax is calculated on the "wholesale price" (Article 4-4A), which usually is the price paid to the local manufacturer. For imported products, the tax is calculated on the price paid to the foreign manufacturer, plus international freight and freight insurance (CIF price), plus port taxes and expenses, and plus custom duties (Article 4B together with Articles 129-134A of the Customs Ordinance). Naturally, this leads to a higher tax rate than if the tax was paid only on the price paid to the manufacturer. Also, importation is often subject to a special system called TAMA, whereby a certain percentage is added to the actual import price for the sake of calculating the tax liability.²⁰ This system does not apply to locally made products. In a Trade Policy Review on Israel, the GATT Secretariat wrote about this system: "It appears that the system used to calculate the taxable value discriminates against imports."²¹
   
2. 
   Time of Payment; Importers must pay the tax at the time when the goods are released from the custody of the customs authorities (Article 5(d)), while the local producers are only liable to pay it 30 days after the month in which the goods are sold (Article 5(a) and 5A). As a result, importers may have to finance the purchase tax from their own pockets, while local producers may pay it from proceeds of the sale.
   
3. 
   Deduction of Tax Paid on Components; Local producers of goods are entitled to deduct from their purchase tax liability any purchase tax paid on the raw-material or any component used to produce the final good. Importers are not entitled to do so, even if the imported product incorporates components manufactured in Israel on which purchase tax has been paid (Dorot, 2006). Cars imported into Israel from the EU often incorporate components made in Israel,²² but this does not entitle them to a reduction of the purchase tax.
   
4. 
   Tax Refund for Products Returned to Manufacturer; A local producer can demand refund of purchase tax for defective or non-conforming goods returned to manufacturer during a period of three years within purchase (Article 27(a)). An importer, in contrast, may demand such refund only during a period of six months following importation. ²³
   

In this context, we should note the judgment of the European Court of Justice in Iannelli v. Meroni²⁴ where it was held that in order to apply the prohibition on discriminatory taxation (Art. 90 of the EC Treaty), not only the rate of direct or indirect internal taxation on domestic and imported products, but also the basis of assessment and the detailed rules for levying the tax must be taken into consideration. Based on the above, it would seem therefore that the Israeli purchase tax is also in breach of Article 19 of the Association Agreement.

In Denmark there is no purchase tax on automobiles. There is however a registration duty levied only upon first registration of a motor vehicle within Danish territory. The rates are very high and can reach a level of about 170% of the price of the car.²⁵ Denmark is similar to Israel in that it does not have a domestic production of cars. This high tax has until now survived several attempts to challenge it before the European Court of Justice. Can one conclude from this that Israel's high purchase tax is also legal under the Association Agreement?

However, for used vehicles the Court found the tax in breach of Article 90. The basis for this finding was that Denmark based its tax on used cars on an estimated value which was higher than the real value of the car, with the result that imported used cars were taxed more heavily than used car sold on the domestic market. While no tax was imposed on the sale of used cars within the Danish market which had already been registered in the past, the Court found that the residual tax on used vehicles must be lower than the high rate imposed on imported cars, thus creating discrimination between used cars already inside Denmark and used cars imported there from other Member States. The Court therefore found that Denmark had failed to fulfill its obligations under Article 90 of the Treaty.

The second time the issue was raised was in a preliminary reference by a Danish court. Here the Court's previous obiter dictum on the possibility of challenging the tax under Article 28 was raised.²⁷ The Danish court asked the European Court of Justice whether an indirect tax, such as the Danish registration tax could be considered a measure having an equivalent effect to a quantitative restriction on imports and for that reason prohibited under Article 28. In its judgment the Court noted that since the Danish registration tax was not imposed by reason of the vehicle crossing the frontier of Denmark, but upon first registration of the car, it cannot be considered a charge having equivalent effect to a customs duty falling under Article 25, but rather an internal tax that falls under Article 90.²⁸ The Court then repeated its conclusion of Commission v. Denmark according to which in the absence of any domestic production of cars, the Danish registration tax cannot be considered to be in violation of Article 90. This provision prohibits imposition of taxes on imported products in excess of that imposed "on similar domestic products"; since there are no similar domestic products, the provision has not been violated! As for a possible violation of Article 28, the Court did not rule out the possibility that a tax or any other internal fiscal measure could fall under this prohibition if it impeded the free movement of goods. The Court said:

40. It is true, as [the claimant] pointed out, that the Court held in… Commission v. Denmark that it is not permissible for the Member States to impose on products which, in the absence of comparable domestic production, escape the application of the prohibitions contained in Article 90 EC charges of such an amount that the free movement of goods within the common market would be impeded as far as those goods were concerned.

Dorot, A. (2006), Customs & International Trade Laws, Ramat Gan: Association of Chambers of Commerce (Hebrew), 245-264.

Gutman, L. (2007) "Israel: Record Holder of Car Thefts in the West", 10.7.07 http://cars.walla.co.il/?w=/4705/1134847#section1

World Trade Organization (2005), Trade Policy Review: Report by the Secretariat: Israel Geneva, WT/TPR/S/157, 22 December 2005, 28-29.