The Israel Tax Authority on October 28 published proposals to tax “wallet companies” and wants comments by November 11 by email to [email protected] So here goes: The issue A “wallet company” refers to a company that has made profits and hasn’t distributed them; also known as “cash-box companies.”According to the proposals, the phenomenon of setting up an entity mainly to save tax by accumulating profits and not distributing dividends is not a desirable or just phenomenon. It results in a substantial deferral of tax revenues and forces the government to raise other taxes and slows down commercial activity in the economy. Nevertheless, there is no intention to limit the freedom to incorporate or the ability to operate as an entity.The proposals were formulated by a “wallet company team” after “many discussions” at the suggestion of the Trajtenberg Committee in 2011. The team was headed by Tax Authority director Moshe Asher, and its other members were Prof. Eugene Kandel, chairman of the National Economic Council; Avi Licht, deputy legal adviser to the government; and Frieda Israeli of the State Revenue Commission.Current law Currently, Section 77 of the Income Tax Ordinance deals with closely held companies controlled by five or fewer individuals in which the public has no interest.Section 77 says if the tax director sees that a closely held company did not distribute a dividend to its shareholders within 12 months after the end of any year, and that it can distribute its profits or some of them without harming its existence and business development, and that the result of non-distribution is tax avoidance or reduction, then the tax director is allowed, within three years after the period concerned, to deem a dividend to be paid.The tax director must first consult a special committee and give the company a reasonable opportunity to present its case. Currently, subject to any tax treaty, shareholders who hold 10 percent or more of any rights in a company are taxed on dividends at rates of 30%-32%.In 2014, dividends of “privileged enterprises” in industry or tech will generally be taxed at a rate of 20%. In practice, these provisions are not enforced as they are virtually unworkable.What’s proposed? The wallet team proposes to revive Section 77 for privately held and other companies depending on what they do: • Service companies: These are closely held companies in which all or part if their income is from the activity of shareholders acting as office holders or employees. If a shareholder or an office holder (it’s not clear which) or an “employees’ company’ company” provide services personally on an ongoing basis, the shareholder will be taxed personally on such income at rates ranging up to 52% (in 2014). Nothing is defined and it is unclear what an employees’ company refers to. It might conceivably refer to payroll companies that for a fee put individual business people on their payroll and help them pay their taxes.• Barrier companies: At least half their income is passive investment income but not capital gains, except from share sales. It is proposed that 50% of their post-tax undistributed passive profit will be deemed to be distributed as a dividend, subject to any company law limit on distributions. Such amounts would be taxed at rates of 30%-32% (in 2014).• Accumulation companies: These are other Israeli resident companies with “excessive” accumulate profit, which are defined as undistributed post-tax profits at the end of the year minus 25% of their revenues (not clear how many years’ revenues). Such excessive profits will be subject to an annual tax of 1%, which will not be deductible as an expense.• Shareholders’ drawings: Amounts withdrawn by the shareholders that are not repaid within three months will be taxed as salary or dividend “as applicable.” This will also apply to amounts spent by the company on real estate for the use of the shareholder or the shareholder’s relative. Finally, the tax director will be empowered to order any company to distribute some or all its undistributed profits as a dividend. However, there will be a safe harbor (protection) for any company that already distributed 70% of the profits it accumulated in the seven years ending two years before the end of the year concerned.Comments Here are a few comments for the government to consider: The proposals are both short (five pages) and shortsighted.There are no estimates of the tax supposedly deferred by using a company, nor how much tax has been paid later when companies do pay salaries or bonuses or dividends to their shareholders.The old rules for closely held companies in the US, UK and Israel failed miserably years ago because companies pointed out that the cash was needed to finance existing operations and expand them.If customers don’t pay their invoices on time, the company must dip into its cash reserves to pay salaries and taxes on those salaries on time; the law requires this by the 10th of each month (salaries) and the 15th (taxes).These rules are also highly discriminatory as they only apply to private companies, not public companies. Small and medium enterprises are said to be the engine of growth in the global economy.Private companies have to get by on their own limited resources; they can’t give others a haircut.Profits are not stored under the floor tiles; they are reinvested. If profits are deposited in a bank account, the bank lends that money to other companies or lets them go overdrawn. If the profits are invested in the stock exchange, that enables other companies to raise money from the public and expand operations. If the profits are invested in real estate, that finances more property and helps reduce property prices.The proposals relating to an employees’ company are unclear. If they are meant to refer to payroll companies, why bother? The individuals already pay full taxes.The proposals will affect large and small shareholders. It seems they may even affect stock-option holders in privately held start-up companies controlled by five or fewer individuals. This seems like overkill. It will force start-ups to having at least six unrelated shareholders and option holders.In fact, there may even develop a market for stooges to act as sixth shareholders.South Africans might be reminded of BEE (Black Economic Empowerment) rules, which have not been over successful.If profits are derived abroad, there is no clear indication about the interaction with other tax rules relating to foreign tax credits, controlled foreign companies, foreign professional companies and Israel’s tax treaties.What should the government do? The government would probably do better to focus on what is apparently the most significant loss of tax revenues: transfer pricing in multinational groups, which results in profits on imports and exports being allocated to low-tax jurisdictions. The OECD refers to this as Base Erosion and Profit Shifting (BEPS) and is developing an action plan to address it. The Israel Tax Authority pays little more than lip service to transfer-pricing rules in Section 85A of the Income Tax Ordinance.There is little information on how much is at stake, but it is possible to make a rough estimate. Israeli exports totaled $100 billion (not shekels), and imports totaled $106b. in 2012, according to the latest data from the Central Bureau of Statistics. So Israel’s trade with the rest of the world amounts to about $206b. a year.Suppose, hypothetically, the transfer prices could have been on average 10% more in Israel’s favor applying Israeli transfer-pricing tax rules (anecdotal evidence suggests this might be possible).That would imply additional Israelisource corporate profits of $21b., liable to 25% company tax in many cases, resulting in $5b., or NIS 18b., more tax for Israel. This is only an estimate subject to many assumptions. Nevertheless, even some of that would go a good way toward painlessly plugging Israel’s budget deficit, until the gas-tax revenues arrive and beyond.As always, consult experienced tax advisers in each country at an early stage in specific cases.[email protected] Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.