Should the Taxpayer Or The Tax Authority Repent? The taxpayer’s didn’t keep proper files.
The Israeli District Court has just ruled that going to court may be wrong and going back to court with additional evidence may be bad faith – in the case of Henry Schwarzbaum Vs the Rehovot Assessing Officer (58143-01-23 handed down by Judge S. Bornstein 16.8.26). What’s going on?
Main facts:
The case dealt with complex and evolving Israeli tax rules for employee stock option plans (ESOPs). ESOPs are common in Israel, especially in high tech.
The taxpayer was the Chief Financial Officer (CFO) of the Israeli subsidiary of Applied Materials, a US tech group on the NASDAQ stock exchange. In 1994-1996 he was issued options relating to Applied Materials stock (shares) which he sold over the years 2005-2018.
Currently, Section 102 of the Israeli Tax Ordinance (ITO) enables gains on options and stock to be taxed at 25%. This is better than marginal rates of up to 50% for salary income. Various conditions apply.
However, for stock issued before 2003, the 50% rate was applicable to gains from stock of a foreign parent corporation e.g. Applied Materials.
In 2013 the taxpayer went to the District Court claiming he deserved the 25% tax rate as he exercised the pre-2003 options after 2003. The Court rejected this, imposed 50% tax and made him withdraw his 2013 lawsuit.
In 2021, the taxpayer discovered at the tax office that back in in 2003, he had filed a seemed sale & repurchase election under Section 102 regulations, relating to traded securities like Applied Materials. This would have enabled 25% capital gains tax upon a subsequent actual sale, but now it was too late!
So the taxpayer sued the ITA again, invoking the election and claiming the Israeli tax Authority (ITA) acted in bad faith by not reminding him of it sooner. This second case dealt with different tax years to the first case.
Court judgment:
In the second case, the District Court again ruled against the taxpayer. He should have invoked his election in good time. Therefore, the ITA did not act in bad faith. He also misconstrued two tax rulings obtained from the ITA on December 22 & 23, 1996 (see below).
Illustrative figures:
The judgment does not give exact dates or figures. So let’s illustrate what might have happened based on publicly available information. Suppose Mr X was granted 10,000 Applied Materials (AMAT) options at their market value on January 3, 1994.
The value of 1000 options, once converted to stock, increased from a cost of $23,600 (in 1994) to $303,000 (if sold at the end of 2018) or to around $4,350,000 (if sold now).
The entire increase is taxable gain. The big question is whether the taxpayer should pay 50% tax instead of 25% simply because he forgot he had duly filed the election years ago? That’s an expensive memory loss.
Comments:
This is a tragic case, to put it politely. Here’s what we can glean.
First, keep your own copy of everything important in your own orderly filing system.
Second, the ITA is under no obligation to tell you anything or give you anything. Tax officials are public servants but they don’t necessarily serve the public.
Third, if you discover something too late, it’s too late. But if the ITA discovers something, the ITA is allowed to reopen the case within various time limits, typically 6 years after an assessment, if any, was issued (ITO Sec 147).
Fourth, beware of pushy tax investigators who try to put words in your mouth using hypothetical questions. In this case, an investigator tried unsuccessfully to make the taxpayer agree he had enjoyed a tax deferral. He knew there no tax to defer (because stock options were issued at market value).
Fifth, make sure any tax ruling(s) are crystal clear. In this case, the ITA thought it agreed in two rulings on two consecutive days to defer tax. The taxpayer thought the ITA had also agreed to reduce the tax rate from 50% to 25%. Big difference of opinion.
Sixth, appealing from the District Court to the Supreme Court is okay. Re-appealing back to the District Court with additional evidence was judged to be bad faith.
Seventh because of doubts about the quality of the Israeli justice system, many taxpayers and their advisors settle with the ITA rather than wait and risk it in court.
Eighth, many taxpayers don’t know where their ESOP documentation is and assume the HR (human resources) department can provide a copy. Assume nothing of the sort.
As always, consult experienced professional advisors in each country concerned at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.