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On November 27, 2006 the Knesset Finance Committee passed a long-awaited blacklist of reportable tax transactions, popularly known as "aggressive tax planning." The blacklist is set forth in the Income Tax Regulations (Reportable Tax Planning) 5767-2006 and VAT Regulations (Reportable Tax Planning), 5767-2006.
Similar rules in the US and UK have proven extremely helpful to the tax authorities of those countries in finding out what their taxpayers are up to. Some of those acts may be legal, others may be more questionable.
Consequently, if you commit any reportable tax planning act on the new Israeli blacklist on or after January 1, 2007, you must report it on your annual tax return. The assessing officer may then issue a partial best judgment assessment of your income and tax due, disregarding the act. If the act was considered to be artificial or fictitious, a deficiency fine of 30% of the tax shortfall may be levied, among other things. However, no such exposure arises if you obtain an advance tax ruling from the Tax Authority.
Most of the reportable acts involve using related parties. A related party is generally defined as: (1) spouse, brother, sister, parent, grandparent, descendant, spouse's descendant and spouse of each of them (2) An entity in which the taxpayer holds 25% or more of the taxpayer; a party that holds 25% or more or more of the taxpayer; and a sister entity held 25% or more by a party that holds 25% or more of the taxpayer.
Below is a summary of the blacklist. Items 1, 9 and 10 seem especially likely to impact many international ventures and investments:
1. Management and advice. Payment of NIS 2 million or more by a party to a related party for management or advice or essentially similar, if the payment reduces tax payable as the related party has losses; pays lower rates of tax; enjoys an exemption; is not taxable in Israel thereon; or the payment is not income for the related party. A payment need not actually be paid if it is deducted as an expense by the taxpayer. It is unclear if such payments include the reimbursement of administration, general and overhead expenses or "headquarter expenses."
2. Sale of asset to a related party at a loss of NIS 2 million or more, which is partly or wholly utilized within 24 months after the year of sale.
3. Sale of asset received as a gift from a related party. If the gift was exempt in Israel, the sale takes place within three years and generates a loss of NIS 2 million or more.
4. Sale of asset received as a gift from a related party. Same as 3, except the asset generates a profit which the seller offsets against other losses of NIS 2 million or more.
5. Debt to related party forgiven. If the forgiver is an entity; the amount forgiven (or written off) is at least NIS 1 million; the payment reduces tax payable as the related party: has losses; or pays lower rates of tax; or enjoys an exemption; or is not taxable in Israel thereon; or the forgiveness is not income for the related party.
6. Debt repayment to 25%-or-more shareholder. If the shareholder is an individual, the amount is repaid in the last quarter of the year in an amount of at least NIS 1 million, and at least 25% of the repaid debt is lent back in the first quarter of the following year. This reporting requirement is aimed at uncovering untaxed loans to shareholders.
7. Debts to others assumed by acquirer of an entity. If, within a period of 12 months, the acquirer pays less than the full amount to the others and the acquired entity owes more than the paid amount to the acquirer. The aim appears to be to uncover dividends received by an acquirer from the acquired entity disguised as debt repayment.
8. Acquisition of an entity with tax losses. Acquisition of 50% or more of the means of control of an entity with losses of at least NIS 3 million capable of utilization under the tax law. Acquisitions of control by parties acting in concert and related parties (with 10% or more common ownership) within a period of 24 months are also covered by this reporting requirement.
9. Acquisition or holding by an Israeli resident of 25% of an entity resident in a non-treaty country or the receipt of NIS 1 million in the year from such an entity. This applies if the entity is resident in a country that does not have a tax treaty with Israel and the rate of tax there on any type of income is below 20%. Acquisitions or holdings by parties acting in concert and related parties (with 10% or more common ownership) within a period of 24 months are also covered by this reporting requirement. The aim is apparently to uncover the use of offshore companies, but Israeli residents are already required to report to the Tax Authority if they have an interest in a foreign company. Moreover, in 2007, Israel will have treaties with only 41 countries out of more than 200.
10. Acquisition or holding by an Israeli resident of 25% a treaty country entity or the receipt of NIS 1 million from such an entity. This applies if (a) the entity is resident in a country that does have a tax treaty with Israel, and (b) 50% or more of the value of its assets, directly or indirectly or via any right, are in Israel, or (c) 50% or more of its income is derived from the rental or sale of assets in Israel to an Israeli resident. The above is calculated according to financial statements prepared that year applying generally accepted accounting principles in the country where activity is conducted. Acquisitions or holdings by parties acting in concert and related parties (with 10% or more common ownership) within a period of 24 months are also covered by this reporting requirement. The aim is apparently to uncover Israeli resident investors who use treaty country companies to make money in Israel. But many questions await clarification. For example, do these reporting provisions cover the use of US or UK parent companies with Israeli hi-tech subsidiaries - unless they conduct services, license their technology, hold their technology outside Israel, or simply derive over 50% of their income from exports? And when is a group of Israeli resident investors acting together in concert? If you are wondering, consider obtaining an advance tax ruling.
11. Family company. Payment to the taxpayer deducted as an expense if it results in a loss of at least NIS 500,000. A family company is disregarded for Israeli tax purposes, instead the largest shareholder is taxed. The aim seems to be to prevent effectively tax free payments to that shareholder.
12. Construction. Contracting with the owner of a land interest to supply construction services where the consideration is based partly or wholly on the consideration from the sale of the land interest. The aim appears to be to uncover non-payment of real estate "acquisition tax" of up to 5%.
13. Real estate co-investment. Contracting with the owner of a land interest to sell a real estate interest to a group of buyers organized to buy the interest and build thereon via an organizer. The aim appears to be to uncover possible non-payment of real estate "acquisition tax" of up to 5% and VAT of 15.5%.
14. Financial institutions and not-for-profit institutions, if they hold 75% or more of a business alone or together with other such institutions. The aim appears to be to uncover possible avoidance of Wage and Profit Tax (15.5%) in the case of financial institutions and Wage Tax (7.5%) by not-for-profit institutions - these are taxes imposed in lieu of VAT in Israel.
The new regulations also contain broad rules that appear to require all taxpayers concerned to report the above tax planning acts and specifies in which tax years they are required to do so.
To sum up, it seems many taxpayers will need to report such "reportable tax planning acts" even if their motive was entirely bona fide. However, no such need arises if you obtain an advance tax ruling from the Tax Authority. As always, professional advisors should be consulted in specific instances.
The writer is an International Tax Partner at Ernst & Young Israel.