An anonymous District Court case judgement on expense deduction for bribes passed at the end of January this year, has attracted much attention - it is exclusively known as "Company Ltd and Individual vs. Netanya Assessing Officer" (Tax Appeal 001015/03).
In general, Israeli tax law lets taxpayers deduct expenses if they were incurred wholly and exclusively in the production of taxable income (ITO Section 17). In this case a company claimed an expense deduction for bribes paid in the production of income.
The company contacted a foreign government of an unnamed country regarding the possibility of developing an agricultural venture. This involved the large scale export of goods and services from Israel. To clinch the deal with the relevant parties in the country concerned, the company claimed it was necessary to pay "brokerage commissions" to various persons in 1998 at all levels in all the bodies concerned directly or indirectly in the deal, according to local custom in that country. Otherwise, the company claimed it was not possible to sign the deal and proceed with it.
The Israeli Tax Authority would not allow these amounts to be deducted as an expense and claimed that as a matter of policy, bribes are private expenses payable out of after-tax income. Furthermore, bribes are contrary to public order.
The court was asked to consider whether the bribes were deductible as an expense. The court ruled unequivocally that there is no possibility of allowing the taxpayer to deduct the bribes. Allowing bribery payments as an expense for tax purposes would be contrary to the basic law which forms the moral authority to legislate and impose tax and would result in bad taxation - because it does not meet the need to be fair and honest among other things.
The court stated that recognizing bribe payments, even if they occur abroad, would contravene the principle of freedom and the principle of equality. Such recognition would contradict the commitment of the state of Israel to be faithful to the United Nations Charter. This commitment is contained in the Declaration of Independence of the State of Israel, which provides as follows: "The State of Israel will be based on freedom, justice and peace as envisaged by the prophets of Israel; it will ensure complete equality of social and political rights to all its inhabitants irrespective of religion, race or sex; and it will be faithful to the principles of the Charter of the United Nations."
The court went on to point out that the United Nations has passed a number of resolutions which culminated in the United Nations Convention Against Corruption (UNCAC). Part II, Section 12 states with regard to tax matters: "Each State Party shall disallow the tax deductibility of expenses which constitute bribes, the latter being one of the constituent elements of the offenses established in accordance with Articles 15 and 16 of this Convention and where appropriate, other expenses incurred in furtherance of corrupt conduct".
The court ruled that although Israel only signed UNCAC in 2005, this does not mean that Israel's position was different from the UN's position previously. Signing the treaty expressed and clarified the legal situation prevailing before signature, namely the absolute prohibition on bribery including giving bribes to further transactions abroad.
The Organization of Economic Cooperation and Development (OECD) has also issued a recommendation on the tax deductibility of bribes to foreign public officials, which says this that member countries which do not disallow the deductibility of bribes to foreign public officials should re-examine such treatment with the intention of denying this deductibility. The OECD has also initiated a convention on combating bribery.
What about the public order argument? The court went quoted earlier precedents including a Supreme Court case which ruled: "The general purpose of any legislation is to preserve public order and avoid results contrary to itâ€¦. The meaning of "public order" is the values, interests and vital core principles which a society at a given time wishes to uphold, preserve and developâ€¦â€¦Legislation must be interpreted in a way that meets the general purpose - within the framework of public order - of deterring law breakingâ€¦.It is not appropriate for someone who breaks the law to enjoy the fruits of the law by enjoying rights granted by the law". (Dani Benbenishti Bros vs. Official Receiver, Civil Appeal 6416/01, Verdict Nun Zayin (4) 197).
The court stated that recognizing bribes as an expense would turn the Israeli public, which pays taxes, into accomplices of such deeds. At the moral level, such behavior does not fit in with the values of the state of Israel. Any other conclusion would contradict the intention of the legislature. Consequently, as a matter of principle, the court rejected the taxpayer's claim to deduct bribe payments as an expense for Israeli tax purposes.
Furthermore, at the practical level, the payments were not well documented at the time they were incurred and could not be proven. The recipients, when recorded at all, were referred to merely by code names. The court ruled that the documentation that existed was insufficient to serve as evidence of the amounts claimed as an expense.
In addition, the taxpayer's accountants raised the matter of bribery with the local tax assessing office which referred them to the professional division at the Income Tax Commission. There, two officials reviewed the matter and one apparently responded verbally. So the accounting firm wrote a letter to the Tax Authority summarizing aspects apparently concluded in conversations and meetings with the tax officials, including " payments abroad to promote the approval of the deal at the rate of 8 percent - 10%".
The taxpayer claimed this process amounted to a governmental undertaking to allow the bribes as an expense. The court rejected this claim as the Tax Authority had not issued anything in writing and signed, such as a letter, a meeting summary or a "pre-ruling" (advance tax ruling - common practice in cases of uncertainty).
As if this was not enough, there was a further setback. One person in the foreign country concerned received $40,000.
"He was someone in the Cabinet who was due to receive more under an agreement with him, but he didn't do his job. It turned out he didn't have the power and the connections needed in order to move ahead," according to the testimony in the judgement.
As mentioned, this was a District Court case and it remains to be seen if the outcome will be appealed by the taxpayer.
To sum up, the State of Israel Israel owes its existence to a UN resolution. In its 60th anniversary year, Israel has shown it maintains its moral values thanks to the UN and a pluralistic view of public order.
As always, consult experienced tax advisors in each country at an early stage in specific cases.
Leon Harris is an international tax partner at Ernst & Young Israel.
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