One of the last economic vestiges of the 1973 Yom Kippur War is about to be swept away.
After this war, the Israeli government reportedly felt the need to boost the economy and spend more on defense. The result was hyperinflation which raged at rates of over 100% in the late 1970s and early 1980s. Consequently, the monthly rate of inflation reached around 7% per month and the short-term solution was to adjust prices and salaries each month for inflation.
But the underlying problem was too much money chasing too few goods, not unlike present day Zimbabwe. Consequently, the rate of inflation got worse and peaked at a monthly rate of around 22%, which represented an annual rate of around 1,000%.
Finally, in July 1985, the government slammed on the brakes and embarked on a series of economic monetary and fiscal reforms that succeeded in reining in spending, demand and inflation. Among many other steps, the Income Tax Law (Inflation Adjustments), 1985, was enacted. This replaced earlier ineffective legislation in this regard. Similar tax laws found their way to some Latin American countries that also experienced hyperinflation.
The aim of the Inflation Adjustments was to adjust business profits for inflation for Israeli tax purposes. For example, suppose an Israeli start-up company starts making widgets. In year one, the company reports sales of NIS 10 million and costs of NIS 5m. leaving a net profit of NIS 5m. on a "historical cost" basis (no inflation adjustment). That sounds good. But if inflation is running at 100% per year, the company must retain all its year one profit in order pay costs of NIS 10m. in year two, just to make and sell the same quantity of widgets. So historical cost profits may need to be ploughed back in hyperinflationary times, not taxed nor distributed to shareholders.
The Inflation Adjustments law took this one step further. It allowed a deduction from taxable profits for inflation on shareholders equity to the extent it exceeded investment in fixed assets. The thinking is that fixed assets aren't eroded by inflation. For example, shareholders' equity NIS 4m., fixed assets NIS 1m., inflation rate 100%, deduction for inflation (NIS 4m. - NIS 1m. = NIS 3m. X 100%) of NIS 3m.
Also, the Inflation Adjustments law included accelerated depreciation rates, indexation of depreciation amounts and - until the end of 2005 - investments in marketable securities. Inflation is measured according to the Consumer Price Index (CPI) published monthly by the government's Central Bureau of Statistics.
The calculations for the Inflation Adjustments are done on a monthly basis, which results in an awful lot of number crunching. Is that still necessary? Since 1985, inflation in Israel has steadily descended to minimal levels - there was in fact 0.1% negative inflation (i.e. deflation) in 2006.
Consequently, the government has announced that the Inflation Adjustments Law will soon be repealed, apparently from January 1, 2008. The transitional provisions for the repeal remain to be seen and may affect some businesses. For example, will accelerated depreciation rates be allowed to continue? And what about companies over 25% foreign-owned and diamond dealers that were allowed to elect US dollar-based adjustments instead of CPI-based adjustments? Nevertheless, the repeal of this complex legislation seems to be a welcome move. The law has outlived its usefulness.
As always, consult experienced tax and other advisers at an early stage in specific cases and check the terms of the repeal if and when it is enacted.
Leon Harris is an International Tax Partner at Ernst & Young Israel.