The Israeli Finance Ministry has published controversial proposals to tax undistributed profits of Israeli private companies (Report of the Undistributed Profits Review Committee, September 3, 2024). The Israeli Institute of Certified Public Accountants is outraged – should we be?

Background:

In 2013-2021, there were around 200,000 companies that made on average 8.5% profit before tax on sales and retained 71% of their profits. Around 6% of those were professional service companies.

In general, Israeli companies pay 23% company tax on their profits. That leaves a balance of 77% available for dividends. Individual shareholders who hold 10% or more pay up to 33% tax on dividends, resulting in a combined Israeli tax burden of up to 48.41%.

Section 62A of the Income tax Ordinance (ITO) already taxes personal service profits of ”wallet companies” as if they were salary, i.e, up to 50% tax.

Section 77 of the ITO allows the Tax Authority to force companies to declare dividends, but this is done sparingly under Tax Circular 20/2018, targeting mainly passive retained profits over NIS 5 million.

Shareholders don’t always take dividends so the Israeli Finance Ministry is proposing a battery of measures to tax undistributed (retained) profits of companies – especially of lawyers, accountants and doctors. This author is an accountant. But the proposals could impact many more sectors.

What is proposed:

First, the Finance Ministry proposes an excess profit tax regarding private companies with 5 or fewer shareholders that make more than 25% profit on revenues – if revenues are in the range NIS 200,000 to NIS 30m. It is proposed the excess will be treated as salary of major shareholders (10%+) and taxed at rates of up to 50%.

Second, profits from corporate services to partnerships and affiliated companies may be considered salary and taxed similarly – up to 50%.

Third, it is proposed to impose an annual 2% tax on retained profits (like loan interest) after deducting a few “safety cushion” items from those profits: (1) average annual deductible expenses, (2) investments in securities and real estate not for personal use, and (3) NIS 500,000 flat deduction.

Fourth, the ITA would be given undefined broader powers to tax forced dividends.

It is unclear if the above proposals mean quadruple taxation of retained profits of private companies. If so, this would be draconian. Is the war that expensive?

The Finance Ministry predicts the proposals would bring in additional tax revenues of around NIS 5 bn per year.

CPA Institute comments:

The CPA Institute says the measures discriminate against accountants and other service providers. An earlier Tax Director is quoted as saying that in most companies, profits help to keep the company going, not avoid tax.

The CPA Institute asks why its own recommendations of March 10, 2024, were ignored, for example to take into account current year war circumstances before taxing past years’ undistributed profits.

Stick or carrot?

The CPA Institute calls for a carrot not stick approach by bringing back a 2017 incentive. This allowed a reduced 25% tax rate on dividends if companies voluntarily chose to pay a dividend. It was known as a Privileged Dividend (Dividend Mootav).

The Finance Ministry responds by saying this was a temporary voluntary measure (carrot) and what is needed is taxation of all undistributed profits on an ongoing basis (stick method).

Timing:

The proposals take the format of a report. Presumably the proposals will soon be turned into a bill for cabinet approval then Knesset enactment.

Our comments:

It remains to be seen what will be enacted.  There is a war to finance, but these proposals, if enacted, will encourage tax planning and keep those accountants and lawyers pretty busy. Obvious tax planning might include having six shareholders, going public, investing in warehouses, taking salary if it will be taxed below 47%, etc.

National insurance (social security) contributions seem to have been overlooked.

It is unclear whether there will be any exceptions for hitech and non-Israeli investors.

As for foreign investors the proposals pose a double tax threat. Will they ever get a foreign tax credit in their home country for Israeli tax on hypothetical dividends, hypothetical interest or hypothetical salary? Some of Israel’s tax treaties may only allow Israel to tax dividends PAID. But the US-Israel tax treaty allows Israel to tax dividends DERIVED in Israel. Confusing foreign investors is never good.

To sum up:

The Finance Ministry is looking urgently for tax revenues today at the expense of tomorrow. If the proposals are adopted, expect more bureaucracy, less employees and potential harm to foreign investors. The government has alternatives. For example, the OECD’s Pillar 2 plan for 15% minimum corporate tax is being adopted now in many countries – but only in 2026 in Israel.

Next Steps:

Please contact us to discuss any of the above matters further, or any other matter.

As always, consult experienced legal and tax advisors in each country at an early stage in specific cases.

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(c) Leon Harris September 9, 2024