Amid the severe budget deficit created by the war, the Ministry of Finance has published a draft tax and black-capital chapter as part of the 2025 Arrangements Law, containing a long list of painful tax measures. Among them: taxing accrued gains on liquid study funds, freezing the planned increase in the pension tax exemption, scrapping the tourist VAT exemption, freezing tax brackets and credits for three years, taxing undistributed profits in holding and personal-service companies, and raising the surtax on capital gains to 5%. Some measures were already rejected in the past due to public opposition, and are likely to face hurdles again in the Knesset.
The tax and black-capital chapter recently published by the Ministry of Finance includes a long list of painful, far-reaching measures that could significantly increase Israel’s effective tax burden. Under the draft Arrangements Law, the tax measures – expected to pass together with the 2025 budget – are intended to address the enormous deficit created by the Iron Swords war and bring it down to 4% of GDP, by raising taxes across a range of economic sectors. Below is a summary of the main proposed legislative changes:
One of the dramatic measures in the draft Arrangements Law is an amendment to Sections 9(16a) and 9(16b) of the Income Tax Ordinance, which would tax gains accrued in study funds from the day they become liquid. Under the proposal, the taxable event would crystallize when funds are withdrawn, and would apply to gains accrued in liquid funds (i.e., more than 6 years after establishment) from January 1, 2025 onward. If approved, these amendments are expected to turn study funds into an “inferior product” compared with alternative savings and investment vehicles such as investment provident funds, and to trigger redemptions of many existing study funds. Similar proposals have been raised by the Ministry of Finance on several past occasions and were beaten back after drawing fierce criticism, mainly from Israeli labor organizations. This proposal, too, can be expected to face significant obstacles, given its destructive underlying messageת “the time has come to break into savings.”
The draft Arrangements Law also proposes amending Section 9A of the Income Tax Ordinance so that the tax-exempt rate applicable to an eligible pension from 2025 onward will not rise to the planned 67%, and will instead remain at 52%. To explain: in order to encourage savers to leave amounts deposited in their pension funds until retirement age, the Income Tax Ordinance grants an exemption from tax on a proportional part of the pension to be paid to them in the future. Under an agreement the Ministry of Finance signed with the Histadrut labor federation more than a decade ago, a progressive mechanism was set to gradually increase the exemption rate, with a significant jump due to take effect in 2025, raising the rate to 67% (so that the tax-exempt pension amount would stand at NIS 6,318 instead of the current NIS 4,904). The Ministry of Finance now seeks to cancel that increase. However, since this amounts to an explicit departure from a previously signed agreement, this proposal too is likely to face especially high hurdles on its way to becoming law, if it passes at all.
The Ministry of Finance proposes canceling the VAT exemption currently applied to services provided to tourists in Israel, including accommodation, car rental, catering and medical-tourism services. To that end, it proposes repealing Section 30(a)(8) of the VAT Law and revoking Regulation 12b of the VAT Regulations. These provisions were designed, as is well known, to encourage foreign tourists to enter Israel and consume services here. Their cancellation is therefore expected to significantly reduce the volume of incoming foreign tourism and harm the real output of the tourism industry as a whole. We can only wonder: is this the time to deal another blow to a tourism industry already reeling under the weight of the war?
Under this sanitized title, the Ministry of Finance seeks to erode real wages and narrow the reliefs and exemption ceilings set out in the Income Tax Ordinance and the Real Estate Taxation Law. What does this mean in practice? The Income Tax Ordinance and the Real Estate Taxation Law provide for automatic indexation, linked to the consumer price index, of most of the fixed amounts they set – including marginal income-tax brackets, the value of tax credit points, the scope of tax credits for donations to public institutions, the exempt-income ceiling for residential rentals, purchase-tax brackets, and the exemption ceiling for betterment tax on the sale of an eligible residential apartment. Canceling this indexation mechanism, as the Ministry of Finance now proposes, is itself a dramatic measure – no less so – and if approved would, in practice, erode citizens’ net income on the one hand and reduce the tax benefits available to them on the other. All this for a lengthy period of three years (until 2028). This is not the first time the Ministry of Finance has sought to impose a harsh measure of this kind in order to boost state revenue in times of crisis. Indeed, this is a significant step expected to bring billions of shekels into state coffers. Even so, the question arises – is there a genuine need to freeze the tax brackets for such a long period, or would a more proportionate step suffice?
The draft Arrangements Law seeks to adopt the recommendations of the Ministry of Finance team that examined undistributed profits. As a reminder, the team’s recommendations consisted of three main pillars: (1) Taxing “personal-service companies” – taxing shareholders of Israeli companies with a profitability rate above 25% (typically companies providing services through a single individual, such as doctors and lawyers) at the marginal tax rate on their share of company profits beyond that 25% threshold; (2) Taxing holding companies – proposing that holding companies be charged “notional interest” of 2% per year on profits accrued but not distributed to shareholders, beyond a certain amount defined as a “safety cushion”; and (3) Amending Section 77 of the Income Tax Ordinance, which deals with compulsory dividend distribution by order of the Tax Authority, so as to allow the Tax Authority to conduct individual proceedings with companies holding high retained earnings, in order to address undistributed profits in holding companies.
Adopting the framework proposed in the draft Arrangements Law on this issue would significantly and inequitably increase the tax burden on Israeli holding companies and personal-service companies. This is a complex model that would be difficult to implement and enforce, and would create high compliance costs. Beyond that, this framework requires explicit and undesirable legislative intervention in the business decision-making mechanisms of Israeli companies, and in its proposed form would harm the economy rather than benefit it. It should be noted that the team’s recommendations were submitted in parallel with government efforts to promote an “operation” to release trapped profits, under which a reduced tax rate would be imposed on dividends for a limited period, in order to encourage companies to distribute their accrued profits. It is worth recalling that a similar preferential-dividend distribution operation conducted in 2017 was considered especially successful, leading to dividend distributions of roughly NIS 126 billion in that tax year alone!!!
Section 121B of the Income Tax Ordinance, in its current form, provides that an individual is liable for an additional tax (beyond the regular tax brackets) of 3% on taxable income exceeding NIS 721,560 (as of 2024). The draft Arrangements Law proposes setting an additional tax of 2% on individuals’ income from capital sources, including real-estate betterment (excluding income exempt from betterment tax under the Real Estate Taxation Law). This means that taxable income from these sources would be subject to a total surtax of 5%!!!
The tax chapter of the draft also includes a long list of additional measures, among them: an across-the-board increase in purchase tax on vehicles, cancellation of all tax credit points granted to foreign workers and non-citizen residents of the territories, a gradual phase-out of the import-tax exemption for personal imports of tobacco products by Israeli residents, and cancellation of the option to consolidate VAT registration for multiple businesses. The tax chapter of the Arrangements Law also includes several proposed legislative amendments intended to reduce “black capital” and strengthen the Tax Authority’s ability to combat it, including by limiting the deduction of expenses and inputs paid in cash and restricting the recognition of expenses that reduce betterment tax.
Closing thoughts in difficult times: there is no dispute that, at this difficult time for the State of Israel following the Iron Swords war, the government must implement drastic steps to reduce the enormous deficit in the state budget and help rehabilitate the Israeli economy. That said, in our view, in this state of emergency, priority should be given to measures that generate an immediate revenue stream for the state, on the one hand, without disproportionately and inequitably increasing the tax burden, on the otherת such as the preferential-dividend operation successfully implemented in 2017 and/or reviving the voluntary-disclosure procedure, which in past years generated substantial revenue for the state.
