Tax reforms call for serious year-end tax planning

Many tax-related changes were enacted by the Knesset in 2005. What can be done to improve your tax lot?

taxes 2 88 (photo credit: )
taxes 2 88
(photo credit: )
The year 2005 was an eventful year in Israeli tax history. Plenty of changes were enacted by the Knesset including another broad tax reform that takes effect January 1. Earlier this month, Banks Supervisor Yoav Lehman gave in to pressure and granted a six-month transition period on enforcement of new credit regulations, but the law will still go into effect on January 1. Therefore, it is advisable to see whether anything can be done to improve your tax lot before the end of the year - or whether it is worth waiting until next year to carry out any transactions. You should, of course, consult professional advisors in each country before taking specific action. Let's first consider the taxation of personal investments. As discussed in earlier columns, the present multitude of tax rates, rules and reporting procedures will be streamlined. A uniform tax rate of 20% will apply to most dividends, interest and capital gains derived by Israeli resident individuals on Israeli and foreign securities, publicly traded or private investments commencing January 1. In addition, capital losses generated from that date may be set off against other capital gains, dividends and interest from that date. This may be a good thing, but not always. An Israeli resident individual who sells Israeli publicly traded securities on or after January 1 will generally find himself paying capital gains tax at a rate of 20% (instead of 15%) on gains that accrued since the beginning of 2003 (yes, retroactive to 2003). An exemption still applies to pre-2003 gains from Israeli publicly traded securities. These gains are calculated in shekels after excluding the effect of inflation according to the Israeli consumer price index. A resident individual who sells foreign publicly traded securities on or after January 1 will find himself paying capital gains tax at a rate of 20% (instead of 15%) on gains that accrued from the beginning of 2005 and rates of up to 35% (or 49% in certain cases) on pre-2005 gains. These gains are generally calculated in terms of the foreign currency invested on a time pro rata basis. To add insult to injury - in all cases - the 15% capital gains tax rate will increase in 2006 to 25% (instead of 20%) for a major shareholder who holds 10% or more in the investee company concerned. This is a severe penalty for entrepreneurs and founders of companies that went public. If everyone in this situation were to sell Israeli securities in December 2005, the stock market prices could swing to and fro. To avoid this effect, the new tax law (Amendment 147 to the Income Tax Ordinance) allows Israeli residents to carry out a hypothetical sale and repurchase of any class of Israeli or foreign publicly traded securities they hold on any day in the month of December 2005. This is a paper transaction, sometimes referred to as "bed and breakfast transaction" or a "hypo sale" or a even a "step-up transaction." Names aside, the intention is that the investor: (1) elects to pay tax at the old rate - 15% - on the paper gain as if he sold the securities, applying that day's closing market price and (2) marks up his cost price of the same securities as if he repurchased them at the same price. The election is available separately for each class of securities, e.g. Company A common stock, Government B bonds, etc. Is this December 2005 hypothetical sale and repurchase of publicly traded securities worthwhile? This needs to be checked out by each investor. The potential advantages may include locking in the abovementioned 15% tax rate and the ability to offset paper losses on some foreign securities against paper gains on other foreign securities acquired many years before 2005 that would otherwise be mainly taxed at 35%. Potential disadvantages of the December 2005 hypothetical sale and repurchase of publicly traded securities can include the need to pay the tax out of other resources; tax on pre-2005 gains from foreign securities at a rate of 35%; and the inability to get a refund if market prices for those securities decline after 2005. Also, if a paper loss is expected it may pay to wait and crystallize an actual loss in 2006 onwards and offset it against other capital gains of all types as well as dividends and interest from securities. Finally, US citizens residing in Israel probably should NOT elect to pay Israeli tax on a hypothetical sale because they cannot credit the Israeli tax on a hypothetical sale against US taxes - instead they should consider effecting an actual sale in December 2005 and/or an actual sale in the future as originally intended. To sum up, a hypothetical sale and repurchase of publicly traded securities needs careful consideration and will not be worthwhile in quite a few cases. Subject to this, how is a hypothetical sale and repurchase done? The investor must submit a written notification and pay the tax during December 2005 via a bank or broker that is a member of the Tel-Aviv Stock Exchange. This has caused consternation among those who invested in foreign securities via a foreign institution that is not a member of the Tel-Aviv Stock Exchange. The response of the Israeli Tax Authority has yet to be heard. It seems that such investors will have to reach an understanding with an Israeli bank or broker or else report and remit the tax directly to their local tax office. With regard to companies, the regular rates of company tax are set to decrease from 34% in 2005 to 31% in 2006; 29% in 2007; 27% in 2008; 26% in 2009; and 25% in 2010 onwards. Therefore, companies will generally consider whether income can be legitimately deferred to a later year and whether expenses or losses can be accelerated to an earlier year (e.g. by selling slow moving inventory at bargain loss-making prices before the end of the year). For companies that hold publicly traded securities and are assessable under Chapter B of the Income Tax Law (Inflationary Adjustments), 1985, the infamous "Section 6" is to be repealed at the end of 2005 and holdings in Israeli and foreign publicly traded securities will be taxed under regular rules and at regular company tax rates. Such companies cannot elect a hypothetical sale and repurchase. In any event, since regular company tax rates will soon decrease, it may pay to wait until 2006 or later to realize any publicly traded securities at a gain. If there are losses in the business of the company or on the securities, different considerations apply. There are many other types of year-end tax planning to consider where relevant. Following are a few. With regard to tax relief for approved provident fund contributions, the maximum "entitling income" taken into account in 2005 is NIS 85,200 in the case of employment income and NIS 120,000 for non-employment income. Consequently, the maximum payments to an approved provident fund that may qualify for tax relief in 2005 are as follows: *NIS 8,400 for payments by self-employed persons to a retirement or pension plan to claim as a deduction from taxable income (NIS 120,000 X 7% deduction). An 11% deduction is possible if payments exceed 16% of entitling income. *NIS 5,964 for payments by employees to a provident fund to claim a 25% tax credit (NIS 85,200 X 7% limit). *NIS 6,000 for payments by self-employed persons to a provident fund and for life insurance (death risk) to claim a 25% tax credit (NIS 120,000 X 5% limit). *NIS 4,260 for payments by employees for life insurance (death risk) to claim a 25% tax credit (5% X NIS 85,200). *NIS 14,880 for payments by self-employed persons to an approved further education fund (Keren Hishtalmut) to claim a deduction from taxable income of up to NIS 9,585. This is based on maximum income for these purposes of NIS 213,000 in 2005. Payments of 7% are recognized, but 2.5% is not deductible while 4.5% is deductible. Different limits apply to employees and most companies will be aware of them. Note that no tax credit is granted for life insurance premiums of less than NIS 1,644 in 2005. More restrictive rules apply to provident fund contributions and further education contributions by major shareholders holding 10% or more of the company concerned. Anyone with an actual or potential link to a trust (settler, trustee or beneficiary) in Israel or abroad should immediately review all aspects in light of the new Israeli tax regime that will be implemented on January 1. We await the publication of guidelines and new forms from the Israeli Tax Authority. Exemptions may be available if all settlers or all beneficiaries are non-Israeli residents, subject to various conditions (e.g. no Israeli resident to have the ability to control, influence or steer the conduct of the trust). Controversy has arisen due to the difficulty in interpreting some of these requirements and the fact that trusts associated with "multinational families" scattered around the world (wandering Jews) may become fully taxable in Israel in 2006. This may result in double taxation in some cases, including certain American trusts. Senior tax officials reportedly assured the Knesset Finance Committee that such issues would be remedied in regulations to be promulgated within three months after the passing of the new law on July 25, 2005 (Amendment 147 to the Income Ordinance). To date, no such regulations have yet appeared. Charitable contributions to institutions approved under Section 46 of the Income Tax Ordinance qualify for a tax credit of up to 35% if they exceed NIS 370 in 2005, but the contributions will not be recognized if they exceed NIS 2,165,000 or 30% of taxable income, whichever is lower. US citizens residing in Israel should consider contributing to recognized "friends of Israeli charity" institutions in the US with a view to qualifying for a deduction for US purposes and a tax credit for Israeli tax purposes on contributions not exceeding 25% of taxable income, under special rules in the US-Israel tax treaty. Israeli companies should carry out year end planning regarding various matters such as foreign tax credits. They should also plan for possible liability to immediate Israeli tax of 25% on the undistributed income of "controlled foreign corporations" that derive mainly passive revenues or profits and are taxed abroad at a rate of 20% or less. In addition, consideration should be given to paying down intercompany balances to reduce exposure to taxes in Israel and/or abroad on deemed (or actual) interest, among other things. Moreover, a reasonable arm's-length transfer pricing policy should be in place for all intercompany transactions to minimize exposure to additional income taxes and customs or other taxes in Israel and/or abroad. An Israeli business should pay the withholding tax on outbound payments to non-residents of interest, royalties and rent should be paid by the end of 2005 with a view to deducting such items as expenses. Alternatively, the tax should be withheld by March 31, 2006 and remitted within seven days thereafter, with the addition of index linkage plus 4% annual interest accruing from January 1, 2006. The rate of withholding tax is 25% unless clearance has been obtained from the Israeli Tax Authority to apply any applicable tax treaty. [email protected] The writer is an International Tax Partner at Ernst & Young Israel