Treasury decides to remove trapped profits from freeze

It had to happen. After years of dwindling tax revenues the Finance Ministry finally came to its senses in an announcement on the website of the Israel Tax Authority (ITA) on June 19.

Israeli and foreign multinational corporations want to take out of Israel many billions of shekels that are trapped by the tax system. But if they do, they forfeit Israeli tax breaks under the “alternative track” of the Law for the Encouragement of Capital Investment.

What is the ‘alternative-benefits track’?
Under this track, industrial and technology companies can opt for a no-grants and no-tax package. The company must retain those profits. If the company decides to distribute those profits, two dollops of tax become due.

The company must pay: (1) company tax at rates ranging from 10 percent to 25%, depending on the degree of foreign ownership; plus (2) dividend withholding tax at a rate of 15%. The resulting total Israeli tax hit therefore ranges from 23.5% to 36.25% for a company on the alternative track that distributes a dividend.

What is a dividend?
Aside from the trapped profits, a second serious issue arose with the alternative track: What exactly is a dividend? The alternative-benefits track rules contain an obscure but troublesome anti-avoidance rule (Section 51B(b)(1) of the Law for the Encouragement of Capital Investments) that reads: “Each of the following shall be regarded as a dividend distributed... (1) An amount given by an... enterprise to its relative, major shareholder as defined... or to an entity in its control or which is charged to it directly or indirectly...”

Therefore, the ITA claims that a “dividend” includes “downward” investments by an Israeli company in foreign subsidiary companies.

Professional practitioners find this farfetched.

Investments are not dividends, and there is no express requirement to reinvest in Israel.

How does the ITA justify its approach?
The ITA announcement says: “A trapped profit is a profit that receives an exemption from tax until it is distributed or expended in certain circumstances. The basic assumption is that these profits will be invested in activity in Israel... The exemption is intended to encourage companies to invest the profits in plants in Israel and in this way increase productive capacity and employment.”

In other words, the fate of billions of shekels hangs on an assumption because the law is vague. It is not even clear if the trapped profits can be invested in a subsidiary company in Israel.

In practice, the alternative-track exemption was replaced in 2011 by a new clearer regime of tax breaks for industrial and technological “preferred enterprises.”

Preferred enterprises currently pay company tax on all their profits at rates ranging from 5% to 15% (not 25%), and dividends are taxed at 15%.

The resulting total Israeli tax hit therefore ranges from 19.25% to 27.75% for a company with a preferred enterprise under the new 2011 legislation that distributes a dividend.

The new ‘ad hoc’ announcement
The problem is what to do about companies that elected the alternative-track tax exemption for retained profits before the change of law in 2011. They generally remain stuck on the track for profits of the project concerned.

The ITA announcement proposes a solution.

Note that this is apparently only a proposal because there is no procedure yet specified nor even a clear piece of legislation.

The announcement proposes to “thaw” trapped profits by allowing a company tax reduction for distributed profits. The 15% dividend withholding tax would not change.

The aim is to generate immediate tax revenues and reduce a fiscal deficit and thereby lessen other cutbacks that would affect the public.

The company tax reduction is not spelled out, but we are told it will be pro rata; i.e., the size of the benefit will be according to the size of the profits “thawed,” making it “egalitarian” and simple to apply.

There are examples of the company tax reduction in a PDF presentation attached to the ITA announcement. Note that Knesset legislation is usually printed on paper, not PDF presentations.

The examples apparently apply net-present- value principles and assume a 5% discount rate to “years of advancement” (it is not clear what this means). Here are the three examples:

Company A
• Foreign investment: 95%;
• Distribution proportion: 50%;
• Years of advancement: 4.5 years;
• Retained profits: NIS 1,000;
• Ad hoc proposed rate of company tax: 4.5% (instead of 10% under the old law);
• Amount of company tax: NIS 22.5
• 15% dividend withholding tax: NIS 71.6;
• Total taxes: NIS 94.1.

Company B
Foreign investment: 80%;
 • Distribution proportion: 50%;
• Years of advancement: six;
• Retained profits: NIS 1,000;
• Ad hoc proposed rate of company tax: 6.8% (instead of 15% under the old law);
• Amount of company tax: NIS 34;
• 15% dividend withholding tax: NIS 70;
• Total taxes: NIS 104.

Company C
• Foreign investment: 25%;
• Distribution proportion: 50%;
• Years of advancement: eight;
• Retained profits: NIS 1,000;
• Ad hoc proposed rate of company tax: 11% (instead of 25% under the old law);
• Amount of company tax: NIS 56
• 15% dividend withholding tax: NIS 66.5;
• Total taxes: NIS 122.5.

Note that these total taxes assume that NIS 500 was distributed as a dividend. So total taxes in the above examples range from 18.82% to 24.5% of distributed profits, compared with 23.5% to 36.25% under the old law.

To sum up
It remains to be seen what the company tax-rate formula will be and whether it will require legislation. If the ITA announcement is clarified and implemented, it may offer companies on the alternative track a useful tax incentive for distributing profits to shareholders. It will also let the ITA off its own hook regarding “downward dividends”; i.e., profits invested in subsidiaries in Israel and abroad.

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

leon@hcat.co

Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.