Your Taxes: Israel Tax Authority’s view on debt versus equity

The Israel Tax Authority has just issued a circular on founders’ shares that explains the ITA’s view on what is debt and what is equity (Preferred Shares – Classification for Tax Purposes, Income Tax Circular 1/2019 as Amended on 24.7.19). This is important for multinational corporations with Israeli subsidiaries, among others.Preferred shares go under many names in Western countries. They are also known as preferred stock, preference shares and even subordinated stock. Preferred shares are a hybrid financial instrument that typically pay a fixed dividend and confer no voting rights. So if they are not ordinary (common) shares, are they a bond or debenture?This is a perennial hot issue for financial institutions and multinational groups.Will related income payments be considered a deductible interest expense in the country of payment, but classified a tax-favored dividend in the country of receipt? Will they meet regulatory rules for capitalization of financial instruments? And will OECD pronouncements prevent perceived abuse of double non-taxation in paying and receiving countries? (See Actions 2 & 4 addressing BEPS, Base Erosion and Profit Shifting.)The Israeli approachThe ITA circular cites the Israeli Securities Law, Company Law and IFRS International Accounting Standard 32, among others. The ITA’s intention is to adhere to accounting standards where this isn’t abusive. But to address borderline situations, the circular lays down the following guidelines:• In principle, preferred shares should be classified for tax purposes as equity. Preferred dividends should therefore be treated as non-deductible dividends.
• If the events or circumstances facilitating redemption of the preferred shares and/or dividend payment are under the company’s control (e.g. approval of the board of directors), the preferred shares will be classified as equity not debt.
• Nevertheless, preferred shares may be considered as a financial liability (debt) for Israeli tax purposes so long as preferred shares don’t confer voting rights, are classified as financial liability under IAS 32, and the dividend is set at a fixed rate of the par value upon issuance of the preferred shares. In such a case, “dividends” may actually be treated as interest for the payer and recipient.
• IAS 32 contains a series of tests. If there is no contractual obligation to repay a financial instrument is probably debt not equity, but see IAS 32 for more details.
• If the preferred shares are a financial liability under IAS 32 but the dividend rate is not fixed, the matter should be referred to the ITA professional department. This may not always be a speedy process.Examples in the ITA circular
• Example 1: Redeemable preferred shares – would be classified as debt for tax purposes if: They must be redeemed or allow the holder a right to redeem them in the future, are treated as financial liabilities for accounting purposes, and confer no other rights such as voting rights. Fixed rate dividends may be treated as deductible interest expense.
• Example 2: Irredeemable preferred shares – would be treated as equity even if they are treated as financial liabilities for accounting purposes. Dividends would be non-deductible.Final remarksUnlike other countries, Israel has no “thin capitalization” limits on interest expense deduction if the leverage ratio (debt to equity) exceeds prescribed levels. So you can clean out an Israeli company’s profit with interest expenses, provided tax is withheld and the money helps generate taxable income. How much withholding tax? The withholding tax rates range up to 25% (30% for domestic Israeli lenders), subject to any tax treaty.Some tax treaties, such as the US-Israel tax treaty allow reduced withholding tax if a US lender itself borrowed the money concerned. For example, if USCO borrows money at 5% per annum and lends it to ISCO at 6% per annum, you can request withholding tax of 23% of the 1% spread, i.e. 0.23%, and you may have an interest expense in Israel and the US! So it is worth knowing what is debt.As always, consult experienced tax advisers in each country at an early stage in specific cases. The writer is a certified public accountant and tax specialist at Harris Horoviz Consulting & Tax Ltd. [email protected]