Your Taxes: Inflation Law's repeal has ramifications

Here is a summarty of an amendment passed by the Knesset that effectively repeals the Inflation Adjustments Law.

taxes good 88 (photo credit: )
taxes good 88
(photo credit: )
In the 1980s, when the Israeli economy suffered from hyperinflation of Zimbabwe proportions (reaching an annual rate of around 2,000%), the Knesset passed a series of anti-inflation tax measures culminating in the Income Tax Law (Inflation Adjustments), 1985. It was vital to protect businesses from paying tax on inflated profits needed in the business. At the same time, the government wanted to prevent double deductions of mortgaged-fixed assets (deduction for depreciation and interest/indexation on loan finance). These aims were achieved by allowing an inflation deduction from income if equity exceeded fixed assets (after multiplying the difference by the inflation rate over the year/period concerned) and requiring an addition to income if fixed assets exceeded equity. In addition, businesses could index-link depreciation and claim higher depreciation rates. The software needed for this is complex. Nevertheless, in recent years inflation in Israel has been brought under control and is on a par with other western countries at about 3 percent per year. Finally, last February 26, the Knesset passed an amendment that effectively repeals the Inflation Adjustments Law starting in 2008, while prescribing transitional provisions for the businesses that have been applying it until now. Here is a brief summary of the amendment, which will affect most Israeli businesses. With regard to depreciation, regulations allowing higher depreciation rates will continue to apply. Depreciation of assets that were fixed assets in any of the years 2002-2007 will be indexed until the end of the 2007 tax year. With regard to the inflation deduction, until now this was limited to 70% of taxable income. However, any unutilized deduction due to this limit may be deducted in the 2008 tax year. Nevertheless, it need not be deducted from the inflationary amount (i.e. exempt indexation) for the purposes of capital gains tax, land appreciation tax or the Law for the Encouragement of Capital Investments. Indexation will be until the end of 2007. If this inflation deduction results in a loss, it will be treated as a business loss, which can be offset against any other income in the same year or future business income or gains. With regard to long-term projects, mainly building projects lasting more than one year, the inflation deduction is allocated pro rata to "work units" or land in inventory that have not yet been reported for tax purposes. Such allocated inflation deductions will be indexed for inflation until the end of the 2007 tax year. These deductions will be deducted from income from sales of the work units or land in the tax year in which income is first reported. With regard to depreciable fixed assets (other than automobiles) and certain securities, real (inflation-adjusted) losses remain allowable, but the inflation adjustment will be only until the end of the 2007 tax year. Interest expenses on assets not yet put into service were deductible up to certain limits until the end of 2007. These amounts will not be added to cost or included in the calculation of depreciation when the asset is sold. Until the end of 2007, if fixed assets became business inventory and were sold, depreciation indexed up to the month of sale was deductible from income taxed at regular rates. This was because such fixed assets reduced the inflation deduction. Such indexation will now be until the end of 2007. Companies more than 25% foreign-owned, including public companies, may still apply US dollar reporting in lieu of inflation adjustments in shekel terms; to start this in 2008 the relevant election had to be applied by March 31, 2008. Once elected, this election normally cannot be revoked for three years. Nevertheless, given the recent substantial weakness of the US dollar, the relevant regulations were recently amended by the Knesset Finance Committee. Consequently, companies that filed the election in the 2005-2007 tax years apparently may change their mind and not apply dollar reporting in the years 2007-2008 if they notify the Israel Tax Authority of their decision by May 31, 2008. These are complicated provisions. As always, consult experienced tax advisors in each country at an early stage in specific cases. [email protected] Leon Harris is an international tax partner at Ernst & Young Israel.