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In principle, a "participation exemption" is granted in some countries (such as the Netherlands, France and Canada) to holding companies regarding dividend income and capital gains derived from affiliated investee companies if certain conditions are met. The principal aims are to prevent double taxation and encourage multinational concerns to establish a regional headquarters in that country.
With these aims in mind, Israel has now passed an amendment that aims to foster the use of Israeli holding companies by foreign and Israeli investors to hold investments in companies in other countries.
To qualify for the Israeli participation exemption, various conditions must be met by the Israeli holding company and the foreign investee companies, as summarized below.
The Israeli holding company must satisfy various conditions including the following: incorporated in Israel and its business is controlled and managed in Israel only; not formed pursuant to a tax-deferred reorganization; and an Israeli holding company election, signed by all its shareholders, must be submitted within 90 days of its incorporation;
In addition, for 300 days or more in the year, commencing in the year after incorporation: at least NIS 50 million ($11 million approx) must be invested in equity of, or loans to, the investee companies; and at least 75% of the company's assets must consist of such equity investments and loan balances.
Also, the foreign investee company must satisfy various conditions including the following: resident in a country that has a tax treaty with Israel; or resident in a foreign country with a tax rate for business activity of at least 15% at the time the Israeli holding company invested in it (but there is no requirement that the investee company itself pay 15% tax if, for example, it obtains a tax holiday); at least 75% of its income in the tax year concerned is accrued or derived abroad as income from a business or one-time venture, excluding management fees from a related party, asset sale consideration and dividends from the income of related companies; the Israeli holding company holds an entitling shareholding "package" that confers at least 10% of the investee's profit - the shareholding must span at least 12 continuous months before and/or after income is received.
WHAT USE is the Israeli Participation Exemption? Commencing January 1, 2006, the following types of income will be exempt for an Israeli holding company: capital gains from the sale of an entitling shareholding in an investee company; dividends distributed during the 12 month minimum shareholding period from an entitling shareholding in an investee company; interest, dividends and capital gains from securities traded on the Tel-Aviv Stock Exchange; interest and indexation amounts received from an Israeli financial institution.
In addition, dividends paid by Israeli holding companies to foreign resident shareholders will be subject to 5% dividend withholding tax when paid. However, profits paid or distributable at the year-end by an Israeli holding company to Israeli resident shareholders will be taxable to them as dividend income in that year, whether or not they are actually distributed.
New and returning residents who held shares in an Israeli holding company upon becoming Israeli residents will continue to be taxed on dividends from the Israeli holding company at a rate of 5% for five years afterward.
What tips can we offer? Regular Israeli CFC (controlled foreign corporation) rules aimed at tax haven companies owned by Israeli residents will not apply under the Israeli holding company regime. Therefore profits may be retained and reinvested abroad.
To sum up, the Israeli participation exemption is subject to far more conditions than comparable exemptions in other countries. Foreign investors may therefore take a look, but Israeli multinationals seem more likely to be attracted.
The writer is an International Tax Partner at Ernst & Young Israel