Your Taxes: Back to school for the government?

It's the beginning of September and the kids in Israel are going back to school. It seems some bigger kids ought to join them.

First,here's an exam question. Do people mind paying more taxes and NationalInsurance Institute payments than necessary? Please choose an answer:(a) Yes; (b) No; (c ) Don't be ridiculous - we all saw what happenedlast time this question was put to us.

You get full marks, and there's no need to hand in your exampaper. And yet, strangely enough, it seems the government has justfailed this exam.

What they've done

TheEconomic Efficiency Law (aka the Budget Law) has just doubled the upperincome limit on which NII payments must be paid from NIS 38,415 to NIS76, 830 per month, for the period August 1, 2009, to December 31, 2010.

This may not be relevant to everyone, but it covers a good chunk of the Israeli middle- and higher-level earners and investors.

On theslice of income from NIS 38,415 to NIS 76,830, or any part of it,employees will now have to pay 12 percent national insurance inaddition to income tax of up to 46%, resulting in total payments to thegovernment of 58%. Freelancers (self-employed) will pay 16.23% nationalinsurance, of which 52% is deductible as an expense for income taxpurposes when it is paid, resulting in total payments to the governmentof 58.42% [16.23% plus 46% minus (52% X 16.23% X 46%)].

So the effective top rate of tax and national insurance in Israel is now about 58%.

In 2010, the top rate of personal income tax goes down from 46% to 45%, but this is small consolation.

More means less

The last time a similar thing occurred was 2001-2003. TheIsraeli economy was in dire straits and the upper income limit for NIIpurposes was scrapped. It rapidly dawned on the government that thiswas a huge mistake: government revenues went down dramatically, not up.

Why? Because higher earners are generally smarter people andthey rushed to set up their own personal-service companies. These wouldpay reasonable but not excessive salaries for their shareholders tolive off. The individual would leave remaining income within thecompany until needed and then draw a dividend.

Consequently, the government reinstated the NII income limitand government revenues recovered. So why has the government made thesame big mistake now in 2009-2010?

What we see in our crystal ball

There are already signs of a new stampede to formpersonal-service companies. If so, this is what our crystal ballsuggests will happen, starting now.

• The individual concerned will pay lower graduated income taxrates (and national insurance) on his reasonable but not excessivesalary.

• His personal-service company pays 26% company tax in 2009 and 25% in 2010 on retained profits (not 58%).

• When the individual eventually takes a dividend from thecompany, this will be subject to 25% income tax and zero nationalinsurance - resulting in total company and income tax of 44.5% in 2009and 43.75% in 2010 ( not 58%).

• The same thing happens again if the personal-service companyinvests its retained earnings in real estate, etc., and makes moremoney.

• Result: The government collects less income tax, less national insurance and is kept waiting years for part of it.

The Israel Tax Authority is aware of the problem (more meansless) and has announced it will act against such behavior. But does ithave a case?

Are personal-service companies OK?

Everyone has the right to incorporate a company according to theCompanies Law, 1999. A good reason for doing so is to enjoy limitedliability against claims of creditors; otherwise, the risk of businessfailure would deter almost all economic activity worldwide. Section 6of the Companies Law does allow the court to "raise the corporate veil"(ignore the company) in a few cases that are not relevant in mostnormal circumstances: fraud or running up excessive debt. And Section 2expressly allows "one-man companies" with only one shareholder.

It is advisable that there be contracts between the company andits clients for the performance of the services and that they beperformed in practice.

There is a legal and tax risk of "employer-employee" relationsbeing deemed to exist in practice if the personal-service company hasonly one client and its shareholder accepts ongoing instructions fromthat client like an employee, without exercising his or her ownprofessional discretion. The terms of the contract and the actualpractice would need to negate such a situation, and legal advice shouldbe obtained (this can be a complex area).

Artificial or fictitious?

Can the Israel Tax Authority claim that a personal-servicecompany can be disregarded as "artificial or fictitious" under Section86 of the Income Tax Ordinance? In the Promedico case (Promedico Ltd.and others vs The State of Israel), foreign companies suppliedpharmaceutical products to an Israeli importer and paid a commission oneach transaction to an offshore entity. The Supreme Court ruled thatthe commission transactions were artificial (i.e. excessive), which isa civil matter. However, the commission transactions in this case werenot fictitious (i.e. nonexistent), which would have been a criminaloffense.

On the other hand, in the court case of Avniel (Civil Appeal77/761), the judge stated that "a person is entitled to form a companyand use it to supply services. Such an arrangement is acceptableinternationally, and if it does not contravene any rules or normalpatterns of behavior in a specific profession... there is nothing atall artificial about it... when business people organize themselves asan entity to sell its services to any taker; I don't regard this asforbidden and I wouldn't even doubt the reality of the transaction if aservice company has no means of providing services, they have to beprovided by its owners." The court ruled that if services (includingmanagement services) are in fact provided, there is no need to look forany additional commercial purpose.

Furthermore, it can be argued that the Israel TaxAuthority cannot intervene in national insurance matters. The NIIoperates under the National Insurance Law and cannot invoke Section 86or any other section of the Income Tax Ordinance.

Tosum up, it remains to be seen if personal-service companies will againbecome widespread in Israel as they did a few years ago, or whether thegovernment will again climb down and leave the NII income limit at itsprevious lower level. Nevertheless, care is needed.

As always, consult experienced tax and legal advisers in each country at an early stage in specific cases.

Leon Harris is an international tax specialist.

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