Your Taxes: Loans used to pay dividends

In general, companies are in business to make a profit. But the cash generated may be used to finance operations or assets.

By LEON HARRIS
The Israeli business and tax world has recently been watching with amazement how to have it both ways. In general, companies are in business to make a profit. But the cash generated may be used to finance operations or assets. So it is not uncommon for a business to borrow cash to finance a dividend distribution to the shareholders. A key question is whether loan interest is a deductible expense for tax purposes if the loan was used to finance a dividend distribution to shareholders. Recently, the Israeli Supreme Court has ruled both ways on this question in different cases - yes and no - but fortunately the Court took the trouble to clarify the position. The general rule in Section 17 of the Income Tax Ordinance is that expenses are deductible from income if they are incurred wholly and exclusively in the production of taxable income (unless a specific exception applies - none in this instance). The first Supreme Court case was the Paz Gaz case (Pazgaz Marketing Co. Ltd. and Pazgaz 1993 Ltd. and American Israeli Gas Co. Ltd. v. Large Enterprises Assessing Officer, Civil Appeals 6557/01, 8849/01, 9391/01, dated November 20, 2006). In 1993, Paz Gaz merged with one of its competitors in the household gas market - Petrolgaz. In order to equalize the value of the two companies just before the merger, it borrowed money and paid a dividend to shareholders. The Supreme Court ruled that although the economic rationale for a transaction is important, provisions in the law cannot be overlooked. Therefore, according to Section 17, there must be a direct link between expenses and the production of income. Consequently, the Supreme Court ruled that interest on loans used to finance the payment of dividends to shareholders is not deductible, for Israeli tax purposes. The second Supreme Court case reached the opposite conclusion and held that interest on a loan used to pay a dividend was deductible (Large Enterprises Tax Office v. Pi Glilot Oil Terminals and Pipelines Ltd., Civil Appeal 8301/04 of October 28, 2007). In this case, a company used surplus cash to buy fixed assets and then borrowed more to pay a dividend out of accounting profits. A review of the financial statements of the company showed that the company would have needed to realize a large amount from its fixed assets in order to pay a dividend out of shareholders funds, which would have resulted in a higher cost than paying the dividend out of borrowed funds. Not unnaturally, immediately after the second case was announced, the unsuccessful taxpayer in the first case sought a re-hearing in the Supreme Court. The Supreme Court rejected the call for a re-hearing but clarified its reasons (Pazgaz Marketing Co. Ltd. and Pazgaz 1993 Ltd. and American Israeli Gas Co. Ltd. v. Large Enterprises Assessing Officer - Additional Civil Hearing 10510/06 of October 29, 2007). In particular, in its clarification, the Supreme Court stated that the factual situation in the Paz Gaz case is different and more complex. In that case, the dividend was paid as part of a merger between two companies to equalize their value, and a dispute arose as to whether the company paying the dividend had sufficient profits to lawfully pay the dividend. Another dispute concerned whether inventory and equipment where purchased with borrowed money, resulting in a double expense deduction. It was also claimed that a principal aim for borrowing money to finance the dividend was to reduce tax. Therefore, according to the Supreme Court clarification, the applicable principles in both cases (Pazgaz and Pi Glilot) may be summed up as follows. Interest on a loan used to finance a dividend may be deductible if: * The company has distributable profits * Cash generated by the profits was used to generate taxable income * Thereafter, the company distributed dividends out of profits that were distributable according to company law * There are clear economic considerations for such a situation * The onus is on the taxpayer to prove this is the case. As always, consult experienced tax and other advisors in each country at an early stage in specific cases. leon.harris@il.ey.com Leon Harris is an International Tax Partner at Ernst & Young Israel.