“LOCKED-IN PROFITS”–THE MINISTRY OF FINANCE
HAS SUBMITTED ITS CONCLUSIONS
During the months of January-August 2024, a team led by the Director General of the Ministry of Finance convened in order to consider the issue of undistributed profits by Israeli companies (“locked-in profits”). The goal of the team was to create an outline that would lead to an increase in the rate of undistributed profits that have accrued in companies and are not used for the purpose of expanding their business activities. The team’s recommendations were recently presented to the government and will be up for discussion in advance of crystallization of the State budget for 2025.
The work of the team focused on two types of companies named in the committee’s report as “wallet companies”: (1) a holding company – Israeli companies that hold subsidiaries and benefit from inter-company dividends that are exempt from tax; (2) occupational companies – companies that supply professional services that are managed by one person, such as: lawyers, accountants, doctors, etc. The committee’s report provides that “wallet companies” of this nature currently hold about 20% of the undistributed profits in the market, such that a deferred distribution of dividends leads to loss of revenue for the State in a scope of NIS 5-6 billion.
The outline presented to the Minister of Finance and the government consists of three main pillars: (1) amendment of section 62A of the Income Tax Ordinance [New Version], 5721-1961 (“the ITO”) – this amendment is intended to apply to companies whose annual business turnover is NIS 200,000-30,000,000 and whose rate of profitability surpasses 25%. It was thus proposed that shareholders in companies of this nature be subject to income tax at the marginal rate with respect to their share in the profits of the company under their ownership, beyond the said 25% profitability (by implementation of the “collapsible ceiling” mechanism”). It is claimed in the report that high profitability is uncommon in business companies, and therefore anyone satisfying these criteria are mostly “occupational” companies, so that the purpose for adding the provision is to reduce the incentive of shareholders to incorporate as a company, as part of a tax planning designed to store accrued profits; (2) enactment of a new provision for the taxation of holding companies – it was proposed that holding companies will be charged “notional interest” in the scope of 2% annually for profits accrued by them and not distributed to their shareholders, over and above the “safety cushion”. The safety cushion is defined in the outline as being higher than: NIS 500,000 of the average permissible expenses by withholding tax in the tax year and in the two years preceding same, and the cost of the company’s assets by withholding investments in securities, investments in land not for its own use, cash and additional investments; (3) amendment of the provisions of section 77 of the ITO that caters for a distribution of dividends that is compelled by order of the Director of the Israel Tax Authority (“the ITA”), thereby enabling the ITA to conduct individual proceedings against those companies whose surplus profits are high, as a means for addressing undistributed profits in holding companies.
Adopting the outline as proposed by the government in its current form will result in a significant increase in the tax burden currently imposed on Israeli holding companies and occupational companies in an imbalanced manner. This entails a complex model whose provisions will be difficult to implement and enforce, and will generate high compliance costs. Moreover, the proposed outline requires the express and undesirable intervention of the legislator in the decision-taking mechanism inherent in Israeli companies and will lead to the economy being impaired instead of benefiting it.
It should be noted that submission of the outline was done simultaneously with the government’s attempt to advance an “operation” to release locked-in profits, in which a reduced tax rate would be imposed on dividends for an allotted period, aimed at encouraging companies to distribute their accrued profits. It is appropriate to mention here that the beneficiary dividend distribution that was undertaken in 2017 was defined as extremely successful, after it resulted in a distribution of dividends in the scope of roughly NIS 126 billion in that same tax year!!!!
It seems to us that during this acute state of emergency which Israel is experiencing, a plan should be chosen that will make it easier for its residents on the one hand, and generate for the State an immediate and significant flow of income on the other hand, such as the beneficiary dividend operation that was successfully implemented in 2017, rather than an outline that leads to an increase in the tax burden disproportionately and in an imbalanced manner, as proposed to the government in the report prepared by the team for considering undistributed profits.
CLASSIFICATION OF RETIREMENT PAYMENTS TO PARTNERS IN A PARTNERSHIP
Recently the Professional Affairs Division within the ITA published a new tax ruling on the classification of retirement payments to partners who retire from the partnership. The subject of the ruling concerned an Israeli partnership that engages in the provision of accounting services and comprises many equity partners. On the date of their retirement, the equity partners are entitled to receive a retirement grant, the payment of which is spread out over a number of years.
It was held in the ruling that retirement grants should be reported by the retiring partners as fruitful income that is subject to tax according to the provisions of section 2(1) of the ITO, and that they should undertake not to report and/or claim that those grants were paid to them for goodwill and/or for non-competing and/or for any other right. At the partnership level, the retirement grants will be allowed as a deduction on the date they are paid, such that a parallel will be created between classification of the retirement payments for withholding tax purposes in the partnership and their classification as work income in the hands of the retiring partner.
Within the ambit of the ruling it was clarified that its applicability is conditional, among others, upon all the retiring partners, including future partners, consenting to its conditions and their agreement to act in accordance with its provisions.
This tax ruling might have relevancy not only for accounting partnership firms but also for all partnerships that comprise many equity partners who are entitled to retirement grants. It is thus important to emphasize that this ruling also tends to allegedly create acceptance with respect to the classification of retirement grants for tax purposes, which in practice would lead to retirement grants and additional rights being subject to the maximum tax rate in the hands of the retiring partner. Accordingly, prior to deciding on adoption of the tax arrangement as proposed by the ITA, it is recommended that its implications be fully considered as should other alternatives at the disposal of the partnership’s partners, which in many cases could lead to a significant reduction in the tax burden that is imposed on them.
SUPREME COURT HOLDING – AN EXEMPTION FROM BETTERMENT
LEVIES SHOULD BE IMPOSED ON THE CONSTRUCTION OF
APARTMENT UNITS ON THE ROOFS OF RESIDENTIAL BUILDINGS
Recently the Supreme Court published a ruling on an appeal submitted by the Jerusalem Local Planning and Building Committee, concerning the question as to the applicability of the exemption from betterment levy on the construction of residential units on the roofs of existing shared buildings, for personal use.
As is known, section 19(c)(1) of the Third Addendum to the Planning and Building Law, 5725-1965 provides an exemption from betterment levy for the construction or expansion of an apartment whose size does not exceed 140 m2 (“the Exemption Provision”). Within the framework of the appeal, the court was asked to rule on the question, after several years of rolling back and forth between the various instances – whether the said exemption should be imposed also with respect to a residential unit that is built on the roof of the shared building following the attachment of building rights?
The court replied to this question affirmatively, by rejecting the appeal of the Local Planning and Building Committee. It thus ruled that there is no room to distinguish 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 will be examined in any case on its merits and are found to have been met.
DECLARATION BY THE DIRECTOR OF THE ITA – A NEW VOLUNTARY DISCLOSURE PROCEDURE WILL BE PUBLISHED IN THE COMING WEEKS
On 5 September 2024 the Director of the ITA, Mr. Shai Aharonovitch, participated in the annual meeting of the Tax Committee convened by the Israel Bar Association. In the meeting, Mr. Aharonovitch informed the audience that despite the delay in finally approving the new voluntary disclosure procedure he expects that it will be published to the public in the next few weeks.
The new procedure is intended to focus on offences in the crypto currency field, but in practice will enable a settlement of various tax offences. The ITA has already clarified that the new procedure will bestow on taxpayers an absolute final opportunity for settling the tax offences committed by them, while granting them immunity from criminal prosecution.
We will provide you with details and the terms of the new procedure when they are published.
* The newsflash is intended to provide subscribers with general information only, and should not in any way be regarded as firm professional advice and/or a definitive legal opinion.
