It's the beginning of September and the kids in Israel are going back to school. It seems some bigger kids ought to join them.
First, here's an exam question. Do people mind paying more taxes and National Insurance Institute payments than necessary? Please choose an answer: (a) Yes; (b) No; (c ) Don't be ridiculous - we all saw what happened last time this question was put to us.
You get full marks, and there's no need to hand in your exam paper. And yet, strangely enough, it seems the government has just failed this exam.
What they've done
The Economic Efficiency Law (aka the Budget Law) has just doubled the upper income limit on which NII payments must be paid from NIS 38,415 to NIS 76, 830 per month, for the period August 1, 2009, to December 31, 2010.
This may not be relevant to everyone, but it covers a good chunk of the Israeli middle- and higher-level earners and investors.
On the slice of income from NIS 38,415 to NIS 76,830, or any part of it, employees will now have to pay 12 percent national insurance in addition to income tax of up to 46%, resulting in total payments to the government of 58%. Freelancers (self-employed) will pay 16.23% national insurance, of which 52% is deductible as an expense for income tax purposes when it is paid, resulting in total payments to the government of 58.42% [16.23% plus 46% minus (52% X 16.23% X 46%)].
So the effective top rate of tax and national insurance in Israel is now about 58%.
In 2010, the top rate of personal income tax goes down from 46% to 45%, but this is small consolation.
More means less
The last time a similar thing occurred was 2001-2003. The Israeli economy was in dire straits and the upper income limit for NII purposes was scrapped. It rapidly dawned on the government that this was a huge mistake: government revenues went down dramatically, not up.
Why? Because higher earners are generally smarter people and they rushed to set up their own personal-service companies. These would pay reasonable but not excessive salaries for their shareholders to live off. The individual would leave remaining income within the company until needed and then draw a dividend.
Consequently, the government reinstated the NII income limit and government revenues recovered. So why has the government made the same big mistake now in 2009-2010?
What we see in our crystal ball
There are already signs of a new stampede to form personal-service companies. If so, this is what our crystal ball suggests will happen, starting now.
â€¢ The individual concerned will pay lower graduated income tax rates (and national insurance) on his reasonable but not excessive salary.
â€¢ His personal-service company pays 26% company tax in 2009 and 25% in 2010 on retained profits (not 58%).
â€¢ When the individual eventually takes a dividend from the company, this will be subject to 25% income tax and zero national insurance - resulting in total company and income tax of 44.5% in 2009 and 43.75% in 2010 ( not 58%).
â€¢ The same thing happens again if the personal-service company invests its retained earnings in real estate, etc., and makes more money.
â€¢ Result: The government collects less income tax, less national insurance and is kept waiting years for part of it.
The Israel Tax Authority is aware of the problem (more means less) and has announced it will act against such behavior. But does it have a case?
Are personal-service companies OK?
Everyone has the right to incorporate a company according to the Companies Law, 1999. A good reason for doing so is to enjoy limited liability against claims of creditors; otherwise, the risk of business failure would deter almost all economic activity worldwide. Section 6 of the Companies Law does allow the court to "raise the corporate veil" (ignore the company) in a few cases that are not relevant in most normal circumstances: fraud or running up excessive debt. And Section 2 expressly allows "one-man companies" with only one shareholder.
It is advisable that there be contracts between the company and its clients for the performance of the services and that they be performed in practice.
There is a legal and tax risk of "employer-employee" relations being deemed to exist in practice if the personal-service company has only one client and its shareholder accepts ongoing instructions from that client like an employee, without exercising his or her own professional discretion. The terms of the contract and the actual practice would need to negate such a situation, and legal advice should be obtained (this can be a complex area).
Artificial or fictitious?
Can the Israel Tax Authority claim that a personal-service company can be disregarded as "artificial or fictitious" under Section 86 of the Income Tax Ordinance? 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 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. nonexistent), which would have been a criminal offense.
On the other hand, in the court case of Avniel (Civil Appeal 77/761), the judge stated that "a person is entitled to form a company and use it to supply services. Such an arrangement is acceptable internationally, and if it does not contravene any rules or normal patterns of behavior in a specific profession... there is nothing at all artificial about it... when business people organize themselves as an entity to sell its services to any taker; I don't regard this as forbidden and I wouldn't even doubt the reality of the transaction if a service company has no means of providing services, they have to be provided by its owners." The court ruled that if services (including management services) are in fact provided, there is no need to look for any additional commercial purpose.
Furthermore, it can be argued that the Israel Tax Authority cannot intervene in national insurance matters. The NII operates under the National Insurance Law and cannot invoke Section 86 or any other section of the Income Tax Ordinance.
To sum up, it remains to be seen if personal-service companies will again become widespread in Israel as they did a few years ago, or whether the government will again climb down and leave the NII income limit at its previous lower level. Nevertheless, care is needed.
As always, consult experienced tax and legal advisers in each country at an early stage in specific cases.
Leon Harris is an international tax specialist.