In the business world, there are no free lunches. In particular, most firms don't give out interest-free or low-interest loans to others. Consequently, to prevent a lender granting a tax-free advantage to a borrower, there are various provisions in the tax law that stipulate a deemed minimum rate of interest (and indexation) for tax purposes. These provisions can result in income for one party without a corresponding expense for the other. Provisions in Section 3(i) (shalosh tet) of the Income Tax Ordinance deal with loans received by any person at an interest rate below the consumer price index (CPI) plus 4 percent per year. They also deal with other rights or options exercised at a price below market value. This section only applies to three specific situations: (1) if employment relations exist between the parties, the resulting benefit is generally taxed as salary (but additional rules apply to employee share option plans); (2) if the borrower supplies services to the lender, the resulting benefit is generally taxed as business income; (3) if the borrower is a 5%-or-more shareholder or a related party of such shareholder, the benefit is taxed as a dividend. In other words, the employee/service provider/shareholder pay taxes at the applicable rates on the benefit they are deemed to receive. Currently, the rate of inflation according to the CPI is about 3.7% per year, so the minimum interest rate for loans granted now is 7.7% per year in shekel terms. In other situations not covered by Section 3(i), there is another section with broad coverage - Section 3(j) (shalosh yud) of the Income Tax Ordinance. Until recently, this latter section imposed tax at a rate of 40% on a business that gave a loan not covered by Section 3(i) to the extent the interest fell below the consumer price index plus 4% per year. In other words, the lender (not the borrower) is taxed. Several exceptions were prescribed, including suppliers' credit and amounts deposited with the State of Israel. Neither of these sections applied to loans that were "fixed assets" of the taxpayer under the Income Tax Law (Inflation Adjustments), 1985. However, this law was terminated with effect from the end of 2007. Consequently, Section 3(j) has just been amended significantly. Following the amendment to Section 3(j), a business is still taxed on deemed income to the extent it gives a loan below the consumer price index (CPI) plus 4% per year (i.e. 7.7% per year currently). However the tax rate has been reduced from 40% to the regular tax rate. In 2008, the regular rate of company tax in Israel is 27%; this will decrease to 26% in 2009 and 25% in 2010 onwards. Any tax losses may now be offset against the resulting benefit, unlike before. Several exceptions now apply to Section 3(j) as follows: â€¢ Customer or supplier debt due to assets or services provided; â€¢ Tax debts; â€¢ Loans given against deposits by the State of Israel or the Jewish Agency; â€¢ Loans covered by Section 3(i) above; â€¢ Deposit or checking (current) account at an Israeli bank or foreign bank approved under the Banking Law; â€¢ Deposits with, or loans to, the State of Israel, municipality, state-owned company or its subsidiary; â€¢ Loans by financial institutions to third parties in the ordinary course of their business; â€¢ Loans by public (charitable) institutions under Section 9(2) of the Income Tax Ordinance; â€¢ Cross-border loans between related parties covered by Israel's transfer pricing regulations; â€¢ Certain interest-free loan notes (see below). Loan notes are commonly used to finance subsidiary companies by Israeli and foreign parent companies as an alternative to share capital. This is because loans may be repaid regardless of whether the borrower has sufficient profits to cover the repayment - whereas the repayment of share capital is allowed in limited cases and court approval is often needed in Israel and other countries. However, interest payments can trigger withholding tax and other issues. Interest-free loan notes issued in 2008 onwards may avoid Section 3(j) if: they are not linked to any index; they are given to a controlled entity (25% or more of the right to profits); are for a term of at least five years and cannot be redeemed before maturity; and redemption is subordinated to obligations and comes only in priority to the distribution of surplus assets in a liquidation. Interest-free loans issued before 2008 are expected to avoid Section 3(j) if: they are for a term of at least one year; their interest is no more than 30% of the rise in the CPI; and they are a fixed asset for the lender, under the Income Tax Law (Inflation Adjustments), Law. As for cross-border interest-free loan notes between related parties, the Israel Tax Authority announced on March 10 that the transfer pricing regulations will be interpreted as not applying to loan notes that are fixed assets under the Inflation Adjustments Law, up until the end of the 2007 tax year. For 2008 onwards, the Tax Authority intends to initiate draft legislation that would specify when a loan note may be treated as a capital investment (like share capital) rather than credit/loan. The proposed legislation would include transitional provisions for loan notes existing at the end of the 2007 tax year. Therefore, multinational groups with a company in Israel should monitor the proposed legislation. 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.