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On its fiftieth anniversary in 1998, Israel abolished exchange control. All of a sudden, Israelis were free to conduct any transaction in any currency in any country.
The children of Israel (and their parents) found this fascinating as they could now legally do business and hold investments in offshore companies incorporated somewhere with an established legal system but with little or no taxes - such as the British Virgin Islands, Jersey, Isle of Man, Switzerland, Lichtenstein or another 60 or so jurisdictions. It is difficult to classify land-locked countries like Switzerland or Lichtenstein as "offshore" but you get the drift - somewhere outside your home country.
The Israeli Tax Authority also got the drift. In 2003, the Israeli tax system was reformed and Israeli residents became taxable in Israel on all their worldwide income (the "personal" or "residency" basis of taxation).
And for good measure, the rules against improper tax planning and offshore companies have been steadily tightened. In this respect, Israel has largely copied other countries, including the US, UK, Canada, Australia and South Africa. On the other hand, tax rates are being gradually reduced - in particular, the tax rate on capital gains, dividends and interest has been reduced from 50% in 2002 to 20% in many cases commencing and other rates are also declining.
So what are the main rules to consider before using an offshore company? The rules include the following:
Doing business in Israel
Control and management
Controlled Foreign Company (CFC)
Foreign Professional Corporation (FPC)
Artificial or fictitious transactions
Reportable tax planning transactions
Withholding taxes and VAT
Following is a brief overview of these concepts. Always check out specific cases fully with professional advisors in each country.
Doing business in Israel: If an Israeli resident individual or company performs activities on behalf of an offshore company, the offshore company would generally be viewed as doing business in Israel. Consequently, the foreign company will be required to pay full Israeli taxes (31% company tax in 2006, 29% in 2007, 27% in 2008, 26% in 2009 and 25% from 2010), in Israel, on income attributable to the activities in Israel.
Control and management: Subject to any tax treaty, a company is deemed to be both resident and taxable in Israel if it was incorporated in Israel or if the control and management of its business are exercised in Israel. This is derived from the old UK principle of "central management and control."
According to a Circular (4/2002) issued by the Israeli Tax Authority (ITA), what matters is the ability to effectively decide, influence the conduct of a business and give binding instructions of decisive effect. The person or body authorized to exercise control and management in practice may be the board of directors, or specific people if they are delegated broad authority and discretion to decide and responsibility for failure. The ITA may also review board resolutions, management agreements, powers of attorney, where the books are maintained, where most major business contacts are located, where new contracts are entered into, where telephone calls are made, the postal address, where administration is conducted and books are stored, etc.
Controlled Foreign Company (CFC): Israeli residents are taxed at a rate of 25% on dividends deemed to be received from a CFC if they hold 10% or more therein.
A foreign company is considered to be a CFC if all of the following conditions exist: (1) The foreign company primarily derives passive income or profits that are taxed at a rate of 20% or less abroad (2) The foreign company's shares are not publicly traded, or less than 30% of its shares or other rights have been offered to the public (3) Any of the following applies: Israeli residents own directly or indirectly more than 50% of the foreign company; Israeli residents own over 40% of the foreign company, and together with a relative of one or more of them, own more than 50% of the company; or an Israeli resident has veto rights with respect to material management decisions, including decisions regarding the distribution of dividends or liquidation.
The taxable deemed dividend is the Israeli taxpayer's share of passive undistributed income on the last day of the tax year. A deemed foreign tax credit is granted against tax on the deemed dividend.
Foreign Professional Company (FPC) : An FPC is deemed to be controlled and managed in Israel, and, accordingly, taxable in Israel at regular rates (31% in 2006).
A company is an FPC if it meets all of the following conditions: it has five or fewer individual shareholders; it is owned 75% or more by Israeli residents; most of its 10%-or-more shareholders conduct a "special profession" for the company; and most of its income or profits are derived from a "special profession."
The "special professions" include engineering, management, technical advice, financial advice, agency, law, medicine and many others. The effect is to make many foreign service companies, onshore or offshore, liable to Israeli company tax. Few other countries have such broad provisions.
Artificial or fictitious transactions: Israel has a broad "general anti-avoidance rule" in Section 86 of the Income Tax Ordinance. This allows the Israeli Tax Authority to disregard a transaction if it is "artificial or fictitious" and it is liable to reduce the amount of tax payable; if a disposition is not in fact carried out; or if a principal objective is improper avoidance or reduction of tax - even if it is not contrary to law. The assessing officer may then issue his own assessment accordingly. In various cases, the Israeli Supreme Court has ruled that artificial transactions lack a commercial purpose, which is a civil matter, while fictitious transactions are non-existent - a criminal matter.
Transfer pricing: Israel has a general requirement that arm's length pricing principles be applied to transactions between related parties (including offshore companies). Proposed new regulations will strengthen this requirement and require a transfer pricing study to be available upon demand within 60 days. Acceptable intercompany pricing methods, in order of priority, will include: comparable uncontrolled prices, comparable profit or profit split method and other methods approved by the Israeli Tax Office. The proposed regulations will apply not only to transfer prices for goods but also intercompany services and credit transactions.
Reportable tax planning acts: According to proposed regulations, an Israel resident who holds 25% or more of any means of control of an entity resident in a country that does not have a tax treaty with Israel (or receives NIS 500,000 or more from such an entity) will be required to disclose this tax planning act in their tax return. The assessing officer may then issue a partial best judgment assessment of their income and tax due, disregarding the act. If the act was considered to be artificial or fictitious, a deficiency fine of 30% of the shortfall may be levied. Additionally, other criminal sanctions may be possible. This will apply to tax returns that need to be filed for the tax return period after the final regulations are published (presumably for the 2007 year onwards).
Withholding taxes and VAT: Israeli banks are required to withhold tax at a rate of 25%-31% from most payments to a foreign resident (e.g. an offshore company) unless advance written approval for a lower rate is obtained from the payor's tax office. In addition, transactions conducted in Israel or with Israeli residents are generally subject to VAT at the standard rate (15.5%) with limited exceptions.
Notwithstanding the above, offshore companies have their uses. There may be non-tax reasons such as the need for privacy or to present a non-Israeli front to nationals of other countries. There may be overseas tax reasons, such as the need to avoid exposure to estate/inheritance taxes (upon death) on securities or real estate investments in countries like the US, UK, France or Spain - such taxes are usually imposed on individuals, not companies - but check out each specific instance.
Finally, there may be sound business reasons for using a low-tax country - the European Court of Justice recently accepted this claim from Cadbury Schweppes, a UK group with subsidiaries conducting treasury operations in the Republic of Ireland where corporation tax on such operations happens to be only 10% or 12.5%. This was a sweet result for Cadbury Schweppes, but the effect would be to defer tax until income is repatriated back home. Deferral is not as favorable as an exemption, but it may be better than nothing.
But if any of the above anti-avoidance rules do apply in a particular case, there may well be full immediate Israeli taxation, and it becomes necessary to claim a foreign tax credit, where possible, under Israel's foreign tax credit rules.
The writer is an International Tax Partner at Ernst & Young Israel