In this article we continue our review of Israeli business taxation. How is taxable income quantified? Taxable income is based on financial statements that are prepared in accordance with generally accepted accounting principles and are derived from acceptable accounting records. New regulations in 2006 require the transfer price and related profit from international intercompany transactions to be on market-based (arm's length) terms. The tax law also prescribes a series of inflation adjustments to the taxable income of businesses in Israel. Alternatively, companies with foreign ownership of more than 25 percent may elect to report income on a US dollar-basis in accordance with detailed rules. At the moment, the rate of inflation is relatively low and the shekel has actually appreciated against the US dollar in 2006. Expense deductibility - In principle, expenses are deductible if they are wholly and exclusively incurred in the production of taxable income. Various items may require adjustment for tax purposes, including depreciation, R&D expenses and vehicle and travel expenses. Payments subject to withholding tax, such as salaries, interest and royalties and overseas expenses are not deductible unless the requisite tax (if any) is withheld and paid to the tax authorities. Inventories - In general, inventory may be valued at the lower of cost or market value. Cost may be determined using one of the following methods: actual; average; or first-in, first-out (FIFO). The last-in, first-out (LIFO) method is not allowed. Provisions - Bad debts are deductible in the year they become irrecoverable. Special rules apply to employee-related provisions, such as severance pay, vacation pay, recreation pay and sick pay. Depreciation - Depreciation at prescribed rates, based on the type of asset and the number of shifts the asset is used, may be claimed with respect to fixed assets used in the production of taxable income. Accelerated depreciation may be claimed in many instances. For equipment acquired in the period July 1, 2005 to December 31, 2006, certain taxpayers may deduct 100% depreciation over the 12 months commencing when the equipment was first put into use - it may straddle two tax years. This applies to taxpayers mainly engaged in industry, software development and production, agriculture and construction, but not packaging, commerce, transportation, warehousing, or the supply of communication, sanitary or personal services, nor taxpayers whose income is mainly from selling assets or real estate interests. If taxpayers cannot or do not claim 100% depreciation, then industrial enterprises may depreciate new assets using the straight-line method at annual rates of 4% to 16% for buildings and 20% to 40% for equipment. Alternatively, they may depreciate equipment using the declining-balance method at rates ranging from 30% to 50%. It is anticipated that these latter rates (not 100% depreciation) will continue to apply in 2007. Following are some of the standard straight-line rates that apply primarily to non-industrial companies: â€¢ Mechanical equipment - 7% to 10% â€¢ Electronic equipment - 15% â€¢ Personal computers and peripheral equipment - 33% â€¢ Buildings (depending on quality) - 1.5% to 4% â€¢ Purchased goodwill - 10% Groups of companies: Subject to certain conditions, consolidated returns are permissible for a holding company and its industrial subsidiaries if the subsidiaries are all engaged in the same line of production. For this purpose, a holding company is a company that has invested at least 80% of its fixed assets in the industrial subsidiaries and controls at least 50% (or two-thirds in certain cases) of various rights in those subsidiaries. For a diversified operation, a holding company may file a consolidated return with the subsidiaries that share the common line of production in which the largest amount has been invested. Group returns may also be filed by an industrial company and industrial subsidiary companies if the subsidiaries are at least two-thirds controlled (in terms of voting power and appointment of directors) by the industrial company and if the industrial company and the subsidiaries are in the same line of production. Detailed rules concerning the deferral of capital gains tax apply to certain types of reorganizations, including corporate mergers, divisions and shares-for-assets exchanges. Relief for losses: In general, business losses may be offset against income from any source in the same year. Unrelieved business losses may be carried forward for an unlimited number of years to offset business income, capital gains derived from business activities or business-related gains subject to the Land Appreciation Tax (capital gains tax for Israeli real estate sales). According to case law, the offset of losses may be disallowed after a change of ownership and activity of a company, except in certain bona fide circumstances. Complex rules apply to the utilization of foreign losses which invariably require individual review. As always, readers are advised to consult professional advisors in each specific instance. The writer is an International Tax Partner at Ernst & Young Israel.