Ongoing payments made by an employer to a provident fund for the severance component are generally not considered taxable income at the time of payment to the fund, but rather at the time the amounts are received by the employees. This applies as long as the amounts and rates of payment to the fund do not exceed the ceilings set out in Section 3(e3) of the Income Tax Ordinance. The issue of excess severance contributions was addressed under Amendment No. 232 to the Ordinance, which came into effect at the beginning of 2017, following years in which a lacuna existed on the matter.
In recent years, a practice has been adopted in Israel whereby many employers opened individual savings insurance policies (“individual policies,” which are not recognized as provident funds) for the purpose of saving additional funds toward employee severance grants (such policies were also referred to as “deferred compensation policies”). Ownership of the individual policies rests with the employers, while employees are registered as the insured and beneficiaries. The funds in the policies were invested and generated returns, and were recorded as assets of the employers during the period prior to their redemption. Employers did not deduct an expense for the deposits made into the policies. Upon termination of employment, the employer (as policy owner) was entitled to withdraw the funds saved in the policy by submitting a request to the insurance company. Accordingly, the employer would pay the withdrawn amount to the employee as a severance grant and withhold tax in accordance with the provisions applicable to severance grant payments.
The accepted interpretive position had been that the individual policies arrangement described above does not create a taxable event at the time the policies are opened or at the time of deposits into them, but only upon withdrawal and payment to the employee. This position was based on the employees’ lack of usage rights over the funds during the life of the policy, the employer’s ownership of the policy, and similar considerations. This position received further support following the issuance of a tax ruling for the Israel Electric Corporation – in the context of an organizational restructuring – under circumstances involving similar deposits into individual policies, a ruling issued during 2018.
However, a new judgment on the matter was recently handed down by the Tel Aviv-Jaffa District Court by Judge Magen Altuvia, in connection with several Israeli companies from the SAP group. In that case, the employer-companies had instituted a unique compensation arrangement for their senior employees, whereby those employees could elect to reduce a certain percentage of their monthly salary and annual bonus, with the reduced amounts being deposited by the employers into individual policies and paid to the relevant employees upon termination of employment (reported for tax purposes as a severance grant). The relevant assessing officers who examined the matter — in the course of withholding tax audits at the employer companies – determined that the deposits into the individual policies under the arrangement constituted payment of employment income at the time they were made, and accordingly assessed the employers for withholding tax and penalties.
The court dismissed the appeals of the employer-companies and ruled that, under the circumstances of the case, the deposits into the individual policies constitute employment income for the employees, subject to tax withholding as of the date of deposit. This ruling was based on a variety of grounds. It was further held that the appellants are entitled to deduct the expense of depositing the amounts into the policies. The court waived the non-withholding penalty after finding that the failure to withhold was not carried out without reasonable justification.
In light of the new judgment, we recommend that any employer who has adopted a similar arrangement in the past re-examine the tax implications applicable to the arrangement, and consider whether changes are required to the compensation structure, to employees’ employment contracts, or to the applicable collective bargaining agreement, in light of the limitations arising from the judgment.
It should be noted that an appeal of the above judgment to the Supreme Court may be filed, and it is therefore important to continue monitoring developments on this matter.
