Recently, the Israeli Supreme Court handed down a judgement on several issues with broad relevance to business operations in Israel (Paz Gaz and the American Gas Company).
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 three issues in this case were:
1) Was the loan interest deductible?
2) Was accelerated depreciation available for gas meter equipment operated 24 hours each day?
3) Could refundable deposits from customers be amortized?
With regard to the loan interest, Section 17 of the Income Tax Ordinance allows expenses to be deducted if they are incurred wholly and exclusively in the production of taxable income, unless a specific exception applies (none in this instance). The District Court had decided there were general economic and financial reasons justifying the interest expense deduction. However, the Supreme Court overturned the District Court decision.
The economic substance is more important than the legal form of a transaction. But 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 dividends to shareholders is not deductible, for Israeli tax purposes. This ruling will affect not only existing businesses but also to investors and parties that acquire shares with borrowed money (leverage).
With regard to gas meter depreciation, the prescribed rate of depreciation for gas meters is 7 percent according to the Income Tax Regulations (Depreciation), 1941. However, Section 4 of these regulations allows the Tax Assessing Officer to double the prescribed rate if abnormal wear and tear is proved because additional shifts are worked. The taxpayer requested double depreciation on the grounds that the gas meters work 24 hours per day and the average life of a gas meter is seven years. The Assessing Officer rejected this request.
The Supreme Court ruled that Section 4 refers to cases where intensive and special use is made of an asset in excess of regular use, resulting in greater depreciation. This exception does not apply to equipment such as gas meters that are made and intended to be used to measure gas consumption throughout each day. Therefore, the Supreme Court ruled that the taxpayer was not entitled to double depreciation.
With regard to amortizing customer deposits (a refundable deposit paid by new customers if and when they stop being customers, usually if they move to a different home), the taxpayer wanted to deduct a valuation allowance regarding the refundable deposits. The Supreme Court ruled that the refundable deposits constitute a contingent liability not an outright obligation, so no valuation allowance could be deducted from taxable income. This has caused some concern as generally accepted accounting principles normally require a conservative approach to be adopted - it seems this is not always the case for tax purposes. Moreover, in 2008 Israel will adopt new accounting rules called IFRS (International Financial Reporting Standards), which refer to the "fair value" of certain items. The Israeli Tax Authority has yet to announce its final policy relating to IFRS accounting.
As always, consult experienced tax advisers at an early stage in specific cases.
Leon Harris is an International Tax Partner at Ernst & Young Israel.