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Your Taxes: Israeli Tax Ruling Impacts Foreign Investment Funds

The Israeli Tax Authority has just published a controversial tax ruling that imposes partial tax on a foreign investment fund with an Israeli presence.

Background:

Section 108 of the Israeli Income Tax Ordinance (ITO) empowers the ITA to collect tax from an Israeli resident who represents a foreign resident. And the Israeli Tax Authority (ITA) claims it must tax gains from the sale of shares and securities as ordinary income if done in Israel, not capital gains, because investment funds are in the business of generating such gains. In other words, the ITA claims that such funds have a taxable permanent establishment (fixed place of business or dependent agent) in Israel. The ITA makes this claim whether or not a tax treaty applies. Over the years Section 108 was considered a deterrent to investing in or via Israel.

With a view to overcoming this deterrent, foreign investment funds generally seek Israeli tax rulings if they invest in Israeli companies assisted by an Israeli consultant or if an investment manager makes Aliya (migrates) to Israel.

Last year the Israeli State Ombudsman stated in his annual report that some of these Rulings apparently exceed the authority of the Israeli Tax Authority (ITA) contained in Section 16A of the ITO. The Ombudsman referred to rulings that purported to grant a blanket exemption or flat rate of tax, rather than adjusting the Israeli tax to that creditable abroad.

Consequently, the ITA has now published a new redacted Ruling (6631/18) that addresses an investment fund that did not qualify for, nor want, a Ruling under Section 16A.

The facts of the Ruling:

The Ruling refers to an investment fund structured as a limited partnership. The only limited partner (investor) is foreign resident company from a country that has no tax treaty with Israel, but is owned by a publicly traded company resident in a country that has a tax treaty with Israel. The general partner is an Israeli partnership in which the limited partners are residents of Israel and Japan. The purpose of the fund is to invest in Israel-related tech companies (“target companies”). Investment decisions are taken by an investment committee of the general and limited partnership that meets in Israel and abroad. An Israeli service company provides various economic advisory functions. The general partner is paid a fixed fee and a success fee (i.e. “carried interest” or ”carry”). The service company is paid an operating fee.

What the Ruling Says:

The Ruling prescribes that gains from realizing investments in target companies will be taxed in Israel pro rata to the portion of overall costs incurred in Israel each year. Comment: It is unclear what happens if several investments are held differing numbers of years.

Fixed management fees and success fees are similarly taxed pro rata to the portion of overall costs incurred in Israel each year. Each partner will be taxed on their share.

Israeli residents in the limited partner are taxed in Israel on a worldwide basis, with a foreign tax credit where applicable.

Regular Israeli tax rates would apparently apply to taxable income – currently 23% for companies, up to 50% for individuals.

The Fund and the service company must register for Israeli tax purposes and report to the ITA its Israeli source income and are considered representatives under Section 108 (i.e. for the foreign investors).

Wage and Profit Tax:

The above Ruling does not mention VAT. But another Ruling (4396/15 of August 4, 2015) and a District Court Case (Equitas case of June 26, 2017, 25935-02-16)  stated that due to the volume of transactions, an investment Fund may not only be subject to income taxation, but also 17% Wage and Profit Tax – this is a tax in lieu of VAT imposed on Israeli banks and insurance companies.

Comments:

This is a tougher stance on the ITA’s part.

The Ruling partially taxes foreign investors in funds with an Israeli presence. It taxes fund managers on their fixed fees and carried interest apparently as ordinary income rather than capital gain. All this without public discussion or explanation.

The policy is questionable as it encourages foreign funds to cut back their Israeli costs and presence.  It seems this Ruling is intended to apply mainly to funds that invest outside Israel. For funds that invest at least $10 million in certain areas of the Israeli economy, especially tech and industry, other fairly standard rulings have been available which recognize capital gains for limited partners/investors upon a sale of a target company and exempt foreign investors on such gains, if various conditions are met. It remains to be seen whether such differing rulings are all fair and reasonable.

Section 108 harks back to British Mandate rule, but the UK has repealed the equivalent section in UK law. Maybe Section 108 should be repealed or replaced as in the UK?

To sum up:

Foreign funds with an Israeli presence should beware of having an Israeli permanent establishment on the income tax side, and wage and profit tax on the VAT side. Consider appropriate structuring and getting appropriate Israeli income tax and VAT rulings.

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

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The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd

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