22.04.2009

Despite all the advances in medical science and plastic surgery, none of us are getting any younger. And going into a retirement home requires money. A recent Supreme Court case resolves some of the tax issues associated with retirement homes and other sheltered housing (Elisha Ltd. vs Haifa Assessing Officer, Civil Appeal 8131/06 of March 29, 2009).

In this case, the taxpayer operated a hospital and sheltered housing. Entry into the sheltered housing could be paid for in a number of ways. The most common way was the ‘‘declining deposit package.‘‘ The tenant deposits a lump sum upon signing up, and 2 percent of its value in US dollar terms is ‘‘eroded‘‘ every year for up to 15 years.

Therefore, the tenant loses up to 30% of his deposit, and this loss becomes income to the operator of the home. If the tenant leaves or dies, the remaining deposit (at least 70% in US dollar terms) is returned to the tenant or his or her heirs. The tenant also pays a monthly maintenance fee to the home.

Main issues

This method of financing an elderly person‘s accommodation in sheltered housing triggered a number of Israeli tax questions:

1) Does interest-free use of the deposit trigger tax on notional (imputed) interest income (Income Tax Ordinance Section 3(i) – Shalosh Tet) at the prescribed rate of 4% above the consumer price index increase per year? The Income tax Authority argued strongly for this.

2) If so, can a corresponding imputed interest expense be deducted, because without the deposit, the home would need to borrow money to finance its activities?

3) Can shekel-dollar exchange differences on the deposit be deducted each year?

4) What about the Income Tax Law (Inflationary Adjustments), 1985?

The court‘s ruling

Clearly, the Supreme Court did not want weird and wonderful tax principles to thwart the public interest.

On the first question, the Supreme Court ruled that the home should not be assessed on notional interest income from the deposit. This was because there is effectively a barter arrangement between the home and its tenants on arm‘s length terms in which:

1) the home takes a loan from its tenants and pays them notional interest at market rates, which represents an expense for the home; and

2) the tenants use this amount to pay for sheltered-housing services, which represents income for the home.

The notional interest expense in the first question was deductible according to the court, because the deposit served in the production of income by financing business activity.

Since there is no reason to believe the parties acted in a noncommercial fashion, the aforementioned notional expense and notional income will be identical and offset each other. That answered the first and second questions.

As for the third question, that the deduction of shekel-dollar exchange differences on the deposit be deducted each year (accrual basis), doubts arise because the deposit amount that the home must eventually return to the tenant or his heirs is uncertain (it could range from 70% to 100% of the original deposit in US dollar terms).

The court accepted that the return of 70% of the deposit was an absolute liability, necessitating annual recognition of shekel-dollar exchange-rate differences. However, the remaining 30% was a contingent liability that only materialized in 18% of cases. The taxpayer did not present an accounting opinion proving that this contingent liability should be recognized each year for accounting and tax purposes. Therefore, the court ruled that the shekel-dollar exchange differences should only be recognized when they materialized, on a cash basis, not the accrual basis.

The fourth question, regarding the Income Tax Law (Inflationary Adjustments), 1985, is less relevant now, since the law was largely repealed at of the end of 2007. The taxpayer argued it was unfair in the relevant years to pay tax on inflationary increments on the tenants‘ deposits. The court ruled that only the original deposit needs to be assessed, not the revalued amount.

As always, consult experienced professional advisers in each country at an early stage in specific cases.

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Leon Harris is an international tax specialist.