A "participation exemption" is granted in some countries (such as the Netherlands, France and Canada) to holding companies for 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 implemented a participation exemption regime on January 1. The purpose is to foster the use of Israeli holding companies by foreign and Israeli investors to invest in active companies in other countries, near and far. To qualify for the Israeli participation exemption, various conditions must be met by the Israeli holding company and the foreign investee companies. The Israeli holding company must satisfy various conditions including the following: it must be incorporated in Israel and its business controlled and managed in Israel only; it may not be 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 or more days in the year, commencing in the year after incorporation, at least NIS 50 million 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: it may be resident in a country that has a tax treaty with Israel; or it may be resident in a foreign country with a tax rate for business activity of at least 15% when 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). Also, at least 75% of its income in the tax year concerned must be accrued or derived abroad as income from a business or from a one-time venture, other than management fees from a related party, asset sale consideration and dividends from the income of related companies; the Israeli holding company must hold an entitling shareholding "package" with rights to enjoy at least 10% of the investee's profit and this shareholding must span at least 12 continuous months before and/or after income is received. What are the benefits of the Israeli Participation Exemption regime? First, 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 requisite shareholding period from an entitling shareholding in an investee company; interest, dividends and capital gains from securities traded on the Tel Aviv Stock Exchange; and interest and (inflation) indexation amounts received from an Israeli financial institution. In addition, dividends distributed to Israeli holding companies to foreign resident shareholders will be subject to a relatively low 5% dividend withholding tax. 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. It is interesting that 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. But the need to form a new special purpose holding company rather than use an existing company should be noted. What happens if a foreign investor sells or liquidates his holding in an Israeli holding company? Until now, Israel has generally imposed capital gains tax on sales of Israeli securities by Israeli and foreign resident investors. Sometimes, Israel's tax treaties override this tax, but not always. However, a broader exemption will now apply from Israeli capital gains tax for foreign investors in Israeli securities - such as shares in an Israeli holding company - if certain conditions are met. In particular, foreign resident individual investors must be resident for at least 10 years preceding the date of acquisition of the investment in a country that has a tax treaty with Israel; they acquire their investment between July 1, 2005 and the end of 2008; and they notify the Israeli Tax Authority of their acquisition within 30 days; and the capital gain is not attributable to a permanent establishment in Israel (generally a fixed place of business) nor shares in companies that principally owned Israeli real estate. This exemption will also apply for 10 years to foreign investors who migrate to Israel and to returning Israeli residents after living abroad for three years. If the investor is a foreign company or other entity, the residency condition is adapted - at least 75% of all its means of control must be held by individuals resident in a country that has a tax treaty with Israel in the 10 years preceding the date the investment was acquired. If the foreign entity's securities are publicly traded on a stock exchange outside Israel, shareholders holding less than 10% will be presumed to be resident in a treaty country unless the opposite is proven. To sum up, the combination of a Participation Exemption regime for Israeli holding companies, plus a low dividend withholding tax and a capital gains tax exemption for their foreign resident shareholders will be welcome news for multinational investors. A list of conditions need to be met but there is no necessity to obtain advance clearance from the Israeli Tax Authority or any other body. Nevertheless, advance tax ruling procedures do exist for those who want added certainty. email@example.com The writer is an International Tax Partner at Ernst & Young Israel.