This tax is a punishment because the lender is taxed on the interest he is deemed to have undercharged.
Israel has detailed tax rules intended to tax hidden economic benefits arising from no-interest and low-interest loans. Section 3(j) (Shalosh Yud) of the Income Tax Ordinance imposes tax on companies and on other businesses required to keep double-entry books if they grant a loan below a minimum rate of interest prescribed in regulations (exceptions are mentioned below).
This tax is a punishment because the lender is taxed on the interest he is deemed to have undercharged, but the borrower cannot deduct interest he didn‘t pay.
The prescribed minimum rate of interest for Israeli tax purposes on loans granted in the last quarter of 2009 is fixed at 3.3 percent per year (unlinked to the rate of inflation). Commencing January 1, 2010, the prescribed minimum rate of interest was reduced to 3% per year, according to a regulation (Number 6078) just published.
There are a number of exceptions to this interest rate:
If the loan was fully covered by another ‘‘back-to-back‘‘ loan that the lender received from an unrelated party, the interest rate and other terms should be the same as those of the back-to-back loan. The other relevant terms are date of receipt of the back-to-back loan (within 14 days before or after), repayment dates for interest and principal.
If the loan was given in certain foreign currencies, the interest rate is 3% per year in terms of that currency. This applies to the US dollar, Canadian dollar, Australian dollar, euro, pound sterling, Swiss franc, South African rand and Japanese yen.
If the loan given in one of the above currencies was fully covered by another back-to-back loan that the lender received from an unrelated party in one of the above currencies, the interest rate, currency and other terms should be the same as those of the back-to-back loan.
For other currencies, the 3% interest rate is calculated on the loan in shekel terms.
For loans given before October 1, 2009, various transitional rules apply, depending on whether the lender was subject to the main inflationary tax-adjustment regime, up to the end of 2007.
If the lender was subject to those rules, the prescribed interest rate for pre-October 2009 loans is the rate of inflation according to the Israeli consumer price index (CPI) until repayment of the loan or the end of 2010, whichever is earlier (even if the loan was given after 2007). If the loan was financed by a back-to-back US dollar loan, the prescribed interest rate is the dollar-shekel exchange rate until repayment of the loan or October 1, 2009, whichever is earlier.
If the lender was not subject to the main inflationary tax-adjustment regime, the prescribed inflation rate for pre-October 2009 loans is the rate of inflation per the CPI (or US dollar exchange rate for dollar back-to-back loans) until repayment of the loan or October 1, 2009, whichever is earlier.
The tax law contains various other important exceptions to the above rules under Section 3(j) and its regulations. These include:
Loans to/from foreign-related parties: These must be on arm,s-length terms. Related parties covered by this requirement include those that control 50% of the other party or those that are 50% or more commonly controlled.
Client and supplier credit.
Loans backed by deposits by the government or the Jewish Agency.
Loans to employees/5%-or-more shareholders/service suppliers under Section 3(i) (Shalosh Tet) of the Income Tax Ordinance. Here the prescribed rate is the CPI plus 4% per year, the tax being payable by the borrower, not the lender, unlike Section 3(j).
Deposits with national or municipal government.
Loans by financial institutions in the ordinary course of their business.
Loans by charities.
Interest-free unlinked promissory notes issued by 25%-or-more subsidiary companies with a term of at least five years.
Certain promissory notes under the old inflationary tax-adjustment regime.
Lenders should consider their finance arrangements at least annually. For back-to-back loans, discrepancies can occur between the actual and prescribed rates of interest. In some cases, it may be worthwhile repaying old loans and replacing them with new loans.
In addition to income tax, bear in mind that loan interest is generally also liable to VAT, currently at a rate of 16%, unless it is paid to an Israeli financial institution.
As always, consult experienced tax advisors in each country at an early stage in specific cases.
Leon Harris is an international tax specialist at Harris Consulting & Tax Ltd.