Your Taxes: VAT quandary for VCs

Now the whole VAT issue has been thrown open by a recent tax ruling and a recent court case.

money (photo credit: REUTERS)
(photo credit: REUTERS)
It used to be thought that venture capital (VC) funds and securities dealers don’t need to worry about VAT in Israel. This is because Israeli VAT applies to a sale or supply of goods or services, but securities are not included in the definition of “goods.” Now the whole VAT issue has been thrown open by a recent tax ruling and a recent court case. Worse still, two alternative taxes may now apply to VC funds and securities dealers.
The ruling:
A VAT Ruling deals with Wage and Profit Tax (4396/15 of August 4, 2015). This is a tax under the VAT law originally intended as tax for banks and insurance companies in lieu of VAT. It is imposed at the same rate as VAT, 17% currently, on wages and profits of financial institutions on their wages and profits, and is deductible for company tax purposes, currently 24%. The result is a composite tax rate of around 35% on the profits for financial institutions.
The ruling points out that the definition of financial institutions in the VAT regulations includes anyone whose business is selling foreign currency or securities or other traded instruments, even if they are held until maturity or redemption. Moreover, this applies even if they invest with their nostro (own) capital and even if they are not companies.
Israeli resident individuals pay 25-33% capital gains, but foreign investors are often (not always) exempt from Israeli capital gains tax. Will they now face a 17% wage and profit tax?
Issues arising:
This Ruling has caused a stir in the Israeli VC fund world. There is little doubt that VC funds are in business and sell, or hope to sell, securities – of start-ups and others. But does the wage and profit tax cover their passive investors – often limited partners who are not allowed to manage the business of a limited partnership. Is nostro trading in securities any different from using other money to trade in securities?
Court decision:
A new decision of the Tel-Aviv District Court just handed down on June 26 in the Equitas Case only adds to the confusion (case 25935-02-16). In this case, a company investing mainly its nostro capital (96%) used an algorithm to make securities investments. In 2011 there were 4.5 million trades totaling NIS 5.6 billion. This was clearly business.
In 2010 the company actually applied to the VAT director to be classified as a financial institution, but later changed its mind and applied to the Tel-Aviv 4 Income Tax Office to stop being taxed as a financial institution. The Income tax Office refused, hence the court case.
On the procedural side, the court was critical of the taxpayer for not reading the legislation properly – only the VAT director can reclassify a financial institution as something else.
But this would not have helped. The court ruled the taxpayer was indeed a financial institution liable to wage and profit tax and that VAT regulations were not ultra vires (unauthorized) as the taxpayer claimed.
Furthermore, if for some reason the taxpayer wasn’t a financial institution, it was still subject to 17% VAT on the margin between purchases and sales or redemptions, according to another section in the VAT Law (Section 19 (b)).
The ruling and the court judgment create uncertainty for securities dealers, VC funds and others. Does wage and profit tax apply? Does VAT apply? Only for nostro dealings? What about expenses? Moreover, what is the income tax treatment in Israel? Is there a permanent establishment under any applicable tax treaty or a taxable representative where no treaty applies?
In practice, if your business is investing in Israeli venture capital or Israeli securities, careful structuring is needed. Also it has become customary to apply for an upfront income tax ruling and/or a VAT ruling from the Tax Authority.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.