Leon Harris and Shai Erez
Last Sunday, March 27, the Israeli Supreme Court, sitting as the High Court of Justice (Bagatz) struck down the Israeli government’s “framework” (Mitveh) for exploiting gas in the Mediterranean and gave the government a year to sort it all out. The “framework” refers to a cabinet decision 476 of August 16, 2015 which sets forth a series of intended legal arrangements for bringing the gas ashore.
The Court judgment rejected a long term stability clause contains a government commitment not to change the framework and to oppose any legislative initiatives, in particular any regulatory change in the fields of taxes, restrictive practices, and so forth, for ten years.
The Court said the government has no authority not to decide and not to act, nor to limit the discretion of its successors and the Knesset on regulatory and tax matters for 10 years.
The Court gave the government a year to sort things out in accordance with the judgment.
This is clearly a complex subject. We discuss below a few aspects on the tax side and take the liberty of suggesting a possible solution for all concerned to consider….
Israeli Gas Taxation In a Nutshell
In January 2011 the Sheshinski Commission published detailed recommendations for updating Israeli taxation of petroleum and gas taxation. The Petroleum Profits Taxation Law was duly enacted in April 2011 and renamed the Natural Resources Taxation Law (hereinafter, “the law”) in 2015, since Israel has not so far discovered oil (=petroleum).
The main feature of the law is the imposition of a levy on windfall gas profits in excess of those needed to make a profit after covering both costs and capital expenditure. On the other hand, the activity concerned is inherently risky and Knesset didn’t want the levy to deter anyone from undertaking the activity.
Therefore, the levy (still referred to as the oil profits levy or the windfall levy) is only payable after recovery (payback) of all the investment plus a return on the investment that makes it all economically worthwhile despite the risk. This is different from income tax which is imposed on ordinary income (active or passive) without regard to recovery of the original investment.
The economic return is measured by means of the R-Factor (i.e. recovery factor). The R-Factor is the ratio of net income from the project divided by the initial investment.
The R-Factor of a gas operator is known as the “Levy Coefficient”; it is the ratio of cumulative income from inception of the project (net of expenses and royalties to the State of Israel) divided by cumulative investment from inception of the project.
Payment of the levy kicks in once the coefficient reaches 1.5, in other words recovery of the full investment plus a return of 50%, at which point the levy is imposed at a rate of 20%.
The levy rate increases gradually to 45.52% once the levy coefficient reaches 2.3.
The levy coefficient is calculated at the end of each year. The levy is then calculated by multiplying the levy coefficient by gas profits. Gas profits are calculated by reference to receipts minus payments in the year concerned.
Paying Levy Installments:
The law allows the Finance Minister to issue regulations for collecting payments on account of the levy, which he duly did. The regulations prescribe, so far, that a gas concessionaire who is liable to the levy must pay on account of the levy at least 8% of annual receipts for 2011, 13% for 2012 and 21% for 2013.
It seems the regulations for those years were fixed at such rates because they applied to a single operator. It will be harder to fix the installment rates when more operators become liable to the levy.
The regulations empower the Israeli Tax Authority (ITA) to reduce the installments if it can be proven the levy will be less. The ITA may also allow payment to be postponed if sufficient cause is shown – the postponed tax will bear interest and indexation for inflation.
The windfall levy is only one tax facing gas operators. They also have to pay a 12.5% royalty to the State of Israel. And they still have to pay company tax – currently 25% of taxable income.
All in all, the Sheshinski Commission anticipated the mix of Israeli taxes on gas profits ranging up to around 62% if all goes well.
Moreover, foreign investors are generally exempt from Israeli capital gains tax, but not in this case. Israeli and foreign investors will pay Israeli capital gains tax at rates ranging from 25% to 32% if they sell an interest in Israeli natural resources, directly or indirectly.
Gas Impasse – Way Out?
To its credit, Israel is establishing a sovereign wealth fund to hold a proportion of gas tax revenues for use by future generations. This follows the similar examples set by countries like Norway and Singapore.
However, there has been intense debate in Israel about how Israeli gas reserves should be applied, culminating in the Supreme Court decision mentioned above.
How can the impasse be resolved?
We would respectfully draw the attention of interested parties to a precedent, apparently, in Section 72A of the Law for the Encouragement of Capital Investments, 1959 (The “Encouragement Law”).
The Encouragement Law grants tax breaks to Israeli industrial and tech enterprises which meet certain conditions (“privileged enterprises”). The tax breaks include company tax at reduced rates of 9%-16% (sometimes less) and dividend withholding tax limited to 20% (sometimes less under Israel’s tax treaties).
Significantly, Section 72A of the Encouragement Law is headed “Stability of Benefits” and reads as follows:
“Anyone receiving approval for, or electing to receive, benefits for a privileged enterprise….shall be entitled to the benefits as prescribed in this law on the date approval was given or the year of the election, as applicable, in accordance with the conditions and limitations that were prescribed as aforementioned.”
Is this a formula for getting the gas out the ground?
As always, consult experienced tax advisors in each country at an early stage in specific cases.
Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.
Shai Erez is a lawyer at Ampeli Tax Law Offices.