Your Taxes: Are illegal payments deductible?

A recent decision of the Supreme Court dealt with a deduction for a truly extraordinary expenditure - bribery.

taxes good 88 (photo credit:)
taxes good 88
(photo credit: )
Companies often try to list all sorts of expenses as deductible for tax purposes, but a recent decision of the Supreme Court dealt with a deduction for a truly extraordinary expenditure - bribery. The Israeli Supreme Court recently ruled on whether bribes and other illegal payments are deductible for Israeli tax purposes and what happens if the payments take place abroad. This follows another fascinating case earlier this year in the Israeli District Court, in which the court stated that recognition of bribe payments, even if they are paid abroad, would contravene the principles of freedom and equality. Such recognition would contradict the commitment of the State of Israel in its Declaration of Independence to be faithful to the United Nations Charter. The District Court pointed out that the United Nations has passed a number of resolutions which culminated in the United Nations Convention Against Corruption. Part II, Section 12 states with regard to tax matters: "Each State Party shall disallow the tax deductibility of expenses which constitute bribes." The latest Supreme Court case is Hydrola Ltd vs. Assessing Officer Tel-Aviv 1. In this case, the taxpayer company (Hydrola) carried out various business activities, including the sale of medical equipment and food products, in the republics of the former Soviet Union. The company conducted its business via agreements with local agents. The company transferred to them large sums of money which were used to pay the agents and for other purposes, including remittances to local parties to promote the success of the deals. The agents were paid through accounts at Israeli banks, and in some cases the company's own directors had power of attorney over these accounts. The issue was whether to allow payments to the overseas agents as an expense deduction. The company claimed the payments were incurred wholly and exclusively in the production of income and were therefore deductible under Section 17 of the Income Tax Ordinance, but the Israeli Tax Authority argued the payments were partly illegal, being bribes. According to the Supreme Court, the payments made by the company's agents abroad were illegal payments for tax deduction purposes, since they were not legal in the country where they were spent, or so it is presumed absent any evidence to the contrary from the company. Also, the payments are not legal in the taxing country, Israel. In other words, they amount to "double illegality" with the weight of the term "double criminality" used in extradition laws. The Supreme Court ruled that amounts transferred to the agents and used for bribery and corruption are not deductible, being illegal if done in Israel and presumably illegal in the country where they were incurred. That is the law for expenses incurred illegally. Allowing such payments as deductible expenses would be contrary to public order. The non-deduction of such expenses is also needed to protect sound public administration and public confidence in the rule of law. The fact that the illegal act was performed outside Israel does not detract from this principle; moreover, it is reinforced by the need to avoid harm to Israeli foreign relations and the need for fair trade. The Supreme Court did allow part of the payments attributable to remuneration of the agents, despite the lack of detailed records, based on the testimony of the agents. The Israel Tax Authority welcomed the ruling in an announcement issued on June 10, 2008. The Director of the Tax Authority indicated that the ruling reflects the position of the Tax Authority that a state authority cannot allow expenses incurred against the law, even if the offense is committed abroad. The announcement pointed out that a bill has been sent to the Cabinet that will expressly provide that bribery expenses will not be allowed as a deduction, as part of the terms of the OECD for Israel's accession to that organization, but the Supreme Court judgment confirms the view that such expenses are not deductible under existing law. leon.harris@il.ey.com Leon Harris is an international tax partner at Ernst & Young Israel.