Trapped Profits in Israeli Tax: Treasury’s New Proposal, September 2024

Between January and August 2024, a team led by the Director General of the Ministry of Finance convened to examine the issue of undistributed profits in Israeli companies (“trapped profits”). The team’s goal was to formulate a framework that would increase the share of undistributed profits accumulated by companies that are not used to expand their business activity. The team’s recommendations were recently submitted to the government and are expected to be discussed as part of the preparation of the 2025 state budget.

The team’s work focused on two types of companies referred to in the committee’s report as “personal companies”:

1. Holding companies – Israeli companies that hold subsidiaries and benefit from tax-exempt inter-company dividends.
2. Personal-service companies – companies that provide professional services and are managed by a single individual, such as lawyers, accountants, and physicians.

The committee’s report finds that these personal companies currently hold roughly 20% of undistributed profits in the economy, and that deferring dividend distribution costs the state an estimated NIS 5–6 billion a year in lost revenue.

The framework submitted to the Minister of Finance and the government consists of three main components:

1. Amendment of Section 62A of the Income Tax Ordinance – intended to apply to companies with annual turnover of NIS 200,000–30,000,000 and a profitability rate above 25%. It is proposed that shareholders of such companies be taxed at marginal income tax rates on their share of company profits exceeding the 25% profitability threshold (applying a “sliding cap” mechanism). According to the report, high profitability is uncommon among ordinary businesses, so companies meeting these criteria are generally personal-service companies; the amendment is meant to reduce shareholders’ incentive to incorporate as a company as part of tax planning designed to accumulate retained profits.
2. A new statutory provision taxing holding companies – proposing that holding companies be charged “notional interest” of 2% per year on profits they have accumulated and not distributed to shareholders, beyond a “safety cushion.” The safety cushion is defined in the framework as the higher of: NIS 500,000; the average of tax-deductible expenses in the tax year and the two preceding years; or the cost of the company’s assets, net of securities investments, real-estate investments not used by the company itself, cash, and other investments.
3. Amendment of Section 77 of the Income Tax Ordinance, which governs compulsory dividend distribution by directive of the Tax Authority’s director, so as to allow the Tax Authority to conduct individualized proceedings against companies holding high retained-earnings balances, in order to address undistributed profits at holding companies.

Adopting the proposed framework in its current form would significantly and unevenly increase the tax burden on Israeli holding companies and personal-service companies. It is a complex model that would be difficult to implement and enforce and would generate high compliance costs. Beyond that, the framework calls for explicit and undesirable legislative intervention in the business decision-making of Israeli companies and, as proposed, would harm rather than benefit the economy.

We note that the framework was submitted alongside government efforts to advance a temporary program to release trapped profits, under which a reduced tax rate would apply to dividends for a limited period, in order to encourage companies to distribute their accumulated profits. It is worth recalling that a similar preferential-dividend program carried out in 2017 was considered especially successful, leading to roughly NIS 126 billion in dividend distributions that tax year.

In our view, given the severe emergency Israel currently faces, a plan that eases the burden on residents while generating an immediate, significant revenue stream for the state — like the 2017 preferential-dividend program — should be preferred over a framework that increases the tax burden disproportionately and unevenly, as proposed to the government in the report on undistributed profits.

How Should Retirement Payments to Partners in a Partnership Be Classified?

The Tax Authority’s Professional Division recently published a new tax ruling on the classification of retirement payments to partners retiring from a partnership. The ruling concerns an Israeli accounting-services partnership with a large number of equity partners. Upon retirement, equity partners are entitled to a retirement grant, paid in installments over several years.

The ruling provides that retiring partners must report the retirement grants as ordinary income taxable under Section 2(1) of the Income Tax Ordinance, and must undertake not to report or argue that these grants were paid to them in respect of goodwill, non-competition, or any other right. At the partnership level, the retirement grants will be deductible when paid, creating symmetry between the classification of the payments as deductible at the partnership level and their classification as employment income in the hands of the retiring partner.
The ruling clarifies that its application is conditioned, among other things, on the agreement of all retiring partners, including future partners, to accept its terms and act in accordance with them.

This tax ruling may be relevant not only to accounting partnerships but to any partnership with a large number of partners entitled to retirement grants. It should be emphasized that although the ruling appears to create symmetry in the tax classification of retirement grants, in practice it results in retirement grants and other rights being taxed at the maximum marginal rate in the hands of the retiring partner. Before deciding to adopt the tax arrangement proposed by the Tax Authority, it is therefore advisable to carefully examine its implications, as well as other alternatives available to the partnership and its partners, which in many cases can lead to a significant reduction in their tax burden.

Does the Betterment Levy Exemption Apply to Rooftop Housing Units?

The Supreme Court recently published its ruling on an appeal by the Jerusalem Local Planning and Building Committee, concerning whether the betterment-levy exemption applies to the construction of housing units on the roofs of existing shared residential buildings for personal use.

As is known, Section 19(c)(1) of the Third Schedule to the Planning and Building Law, 5725-1965, provides a betterment-levy exemption for the construction or expansion of an apartment of up to 140 square meters (the “exemption provision”). In the appeal, after several years of proceedings before various instances, the Supreme Court was required to decide whether this exemption also applies to housing units built on the roof of a shared building following the attachment of building rights.

The Supreme Court answered this question in the affirmative, dismissing the Local Committee’s appeal. It held that there is no basis for distinguishing between the construction or expansion of an apartment on vacant land and the construction of an apartment on the roof of a shared residential building, provided that the conditions of the exemption provision are examined on a case-by-case basis and found to be met.

When Will the New Voluntary Disclosure Procedure Be Published?

On September 5, the Director of the Israel Tax Authority, Mr. Shay Aharonovich, participated in the annual meeting of the Israel Bar Association’s Tax Committee. At the meeting, Mr. Aharonovich announced that despite delays in finalizing approval of the new voluntary disclosure procedure, it is expected to be published to the public in the coming weeks.

The new procedure is intended to focus on crypto-related tax offenses, but in practice will allow the settlement of tax offenses of all kinds. The Tax Authority has previously clarified that the new procedure will give taxpayers a definitively last opportunity to settle tax offenses they have committed, in exchange for immunity from criminal proceedings.