Your Tax in '06

What are the limits of tax planning?

By LEON HARRIS
April 13, 2006 00:35
4 minute read.
Your Tax in '06

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At Passover, we wish each other a happy and kosher occasion. It seems this is now a tax requirement, as well. From time immemorial, taxpayers have felt the urge to pay less tax. The economies of some "offshore financial centers" depend on it - quaint places like Bermuda, Jersey or Switzerland. And yet, we take for granted the many substantial things the government provides us, such as roads, water, schools and security. Currently, the tax take in Israel ranges up to 49% for individuals and up to 48.25% on distributed profits of companies. In addition, national insurance (social security) contributions are payable at various rates ranging from zero to approximately 16%. Tax planning can take many forms. For example, planning to use legislated tax breaks for industry, foreign investors or new immigrants; use of applicable tax treaties; use of companies or trusts in low-tax countries; using a tax efficient business model - and so forth. Tax planning is legal, but within limits. What are those limits? There have been recent developments in this area in Israel and more are expected soon. Israel has a broad "general anti-avoidance rule" in Section 86 of the Income Tax Ordinance. This basically says that the Israeli Tax Authority may 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 immodest assessment accordingly. So what does "artificial or fictitious" mean? In the Promedico case (Promedico Ltd. and others vs. The State of Israel), foreign companies supplied pharmaceutical products to an Israeli importer and paid a commission on each transaction to an offshore entity. The Israeli Supreme Court ruled that the commission transactions were artificial (i.e. excessive), which is a civil matter. However, the commission transactions in this case were not fictitious (i.e. non-existent), which would have been a criminal offense. In July 2003, in the Rubinstein Case (Large Enterprise Assessing Officer vs. Yoav Rubinstein & Co.) a failed fish rearing company with no assets or activity was acquired by new owners who changed its name, turned it into a construction company and tried to offset past fish rearing losses against its construction profits. The Supreme Court found this altogether fishy - and ruled it involved an "artificial" series of acts that amounted to an artificial transaction. This was because the transaction: (1) aimed to reduce tax, (2) had no commercial purpose and (3) did not follow normal patterns of behavior. It is necessary to balance the right of the taxpayer to carry out tax planning with the public interest in having an equitable and fair tax system. In January 2006, the Supreme Court applied the above Rubinstein case principles and clarified the key tax planning ground rule in the Shitrit Case (Silvan Shitrit vs. Assessing Officer Tel-Aviv-Yafo 4.). This concerned an architect who liquidated a profitable company and moved its business contracts, premises and employees into a virtually identical new company. The aim was to enjoy a special reduced tax rate when its profits were paid to him as part of the winding up process. However, the Supreme Court again took a dim view. It ruled that, in practice, the key test for distinguishing between a "Kosher Transaction" (the judges' very words) and an "Artificial Transaction" is to see if the transaction has a commercial purpose. The Supreme Court concluded that liquidation of the architect's company was devoid of any commercial purpose, making it an "artificial transaction." Therefore, the Tax Authority was within its rights under Section 86 to disregard the liquidation and impose full tax. Now that we know what is an artificial or fictitious transaction, how will the Tax Authority find out about it? Until recently, it was thought possible to avoid penalties by obtaining a supporting professional opinion on the validity of the tax planning and/or by making sufficient disclosure in the tax return. However, some people thought it was sufficient if the disclosure was tucked away in small print in financial statements attached to a tax return. To counter such sneaky actions, a recent amendment enables the Finance Minister to issue a blacklist of reportable tax planning acts. We currently await publication of the blacklist. If you committed any reportable tax planning act on the blacklist (once it is published) 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 shortfall may be levied and additional fines or even imprisonment for a year also may be imposed. That is an offer of free accommodation you can do without. leon.harris@il.ey.com The writer is an International Tax Partner at Ernst & Young Israel.

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