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In two weeks, the tax reforms recommended by the Rabinovitch Commission will go into effect. In recent years, there have been some unsuccessful attempts to tax the capital market. One of the reasons for the approval of the current tax reform law is the compromise on the shortcomings encountered by the Ben-Bassat Commission reforms of 2000, such as the taxation of training funds (keren hishtalmut).

It is important to remember that despite completion of the legislative process, the regulations for the reforms have yet to be published. The Income Tax Commission also has yet to settle several issues, such as the manner in which negotiable bonds will be taxed.

The Rabinovitch Commission debated three main issues: a uniform tax on all financial instruments versus varying taxation rates; general reporting versus tax deduction at the source; and territorial-based taxation versus personal taxation.

l Varying tax rates - Unlike the Ben-Bassat Commission, which recommended a uniform tax on all assets and investments of 25 percent, the Rabinovitch Commission decided to differentiate between tax on real profits (taking inflation into account) on stocks and index-linked bonds and on all other non-shekel instruments, and a nominal tax on shekel-linked bonds, short-term loans and shekel deposits.

The commission's decision was based on the understanding of the difficulty in calculating real tax on some of the shekel investments. The decision was to impose a 15-percent tax on real profits and a tax of 10 percent on nominal shekel profits.

The commission also decided on different tax rates for different investment instruments, and ruled in favor of the gradual implementation of these reforms by 2007. Thus, for example, the tax on foreign stocks and bonds will stand at 35 percent until 2007, compared to 15 percent on Israeli stocks and bonds. In 2007 the tax on the foreign securities will be lowered to the tax level on Israeli securities.

l No compulsory reporting - Due to objections from the Income Tax Commission, the Rabinovitch Commission chose to refrain from recommending compulsory reporting, preferring instead a system of tax deduction at source. A taxpayer interested in offsetting losses can file an income tax return or can have the bank apply the losses to offset tax on profits, provided that a single bank account is involved. This system turns the banking system into a tax collector.

The banking system will report all securities transactions to the income tax authorities, whether tax is being charged on them or not. A regulation was made recently obligating bank customers to file returns if they receive over NIS 12,000 a year in interest. The regulations similarly require full reporting of all securities transactions, which will bring all those who invest in tax-exempt instruments and taxable mutual funds into the circle of those who file returns, even though the funds were designed specifically for those who were interested in avoiding any contact with the income tax authorities. In practice the compulsory filing will apply to the banks and not to the investors.

l Personal taxation - The taxation system practiced in most Western countries is a personal system, in which taxation applies to the country's citizens irrespective of the geographic source of their income or capital gains. Until now Israel employed a territorial taxation system, in which different tax rates applied to profits depending on their geographic source. This system enabled Israeli citizens to avoid paying taxes on capital gains, dividends and interest on overseas investments. The liberalization of the foreign currency market, completed in 1998, also allowed the unlimited transfer of funds abroad. The Rabinovitch Commission's decision to switch to personal taxation will obligate every Israeli citizen who has investments overseas to report their income annually.

Gradual change

l The reduction of taxes on wages in exchange for capital gains taxation - The Rabinovitch Commission's reforms are based on reducing taxes on wages, while imposing taxes on other income that has hitherto been exempt, including capital gains. The reduction of taxation on wages will be implemented gradually, through 2008.

The commission's basic assumption was that high taxes on wages are a disincentive to work, harm economic growth and increase the incentive to evade taxes. The changes aim to broaden the tax base by reducing the gap between the tax burden on capital gains and that on income from personal labor.

l The transition period - Recognizing that it will take time to set up the required computing and reporting mechanism, the commission decided that a financial body that does not have these systems in place by January 2003 will be able to charge a standard transaction tax when an instrument is redeemed, rather than calculate (and tax) the profit. During the first half of 2003 this tax will be 0.5 percent, increasing to 1.0 percent in the second half of the year. The tax deducted will be final, unless the taxpayer prefers to file an abbreviated return, in which case the tax will be calculated on the profits. From 2004, taxes will be deducted from the profits when instruments are redeemed.

l Purchase price - real capital gains will be calculated using the original purchase price and the sale price, adjusted for inflation. The original price of a security purchased before January 2003 will be the average price of that security on the Tel Aviv Stock Exchange on the last three days of 2002. If a taxpayer proves that the historical purchase price of the security was higher than the average price on the last three days of 2002, the original price will be considered the purchase price and will serve as the basis for calculating the tax.

l The symmetry principle - This principle states that capital gains are taxable and capital losses are recognized for tax purposes. Nevertheless, this symmetry is not absolute because only the nominal value of losses are recognized. Furthermore, losses from taxable mutual funds will not be eligible for offsetting other profits and investors who redeem mutual fund units at a loss will lose their accrued losses.

l The redemption principle - A taxpayer is obligated to pay taxes only upon redeeming capital gains from securities, or upon receipt of interest or dividends, or upon redeeming a savings plan. Capital gains "on paper" are not taxable as long as they are not realized. Similarly, theoretical losses cannot be used to offset profits.

l The offsetting principle - Capital losses can be used to offset capital profits from securities. If a taxpayer has a negative profit balance in one year, it can be carried to the following years with no time limit. Until 2006, this balance can be used only to offset future profits on capital gains and not interest earnings or dividend. From 2007, losses will also be applicable to interest earnings and dividends.

The losses will be calculated on their tax basis. For example, if an investor earns NIS 50,000 on shares, he will owe NIS 7,500 in taxes (15 percent). If he lost NIS 50,000 on a bond investment, the tax loss is NIS 5,000 (10 percent). Therefore, he will have to pay the difference (NIS 2,500).

Previous attempts at tax reform in Israel

l 1964 - Capital gains tax on the stock exchange. This tax was cancelled within a year (Finance Minister - Pinhas Sapir).

l 1982 - Peace for Galilee transaction tax of 2 percent. Cancelled in 1984 (Finance Minister - Yoram Aridor).

l 1990 - Tax on real profits from interest and on profits from provident funds and life insurance policies (20 percent). Cancelled within five months (Finance Minister - Yitzhak Moda'i).

l 1994 - 10 percent capital gains tax with no offsetting, or 20 percent with offsetting. Cancelled in 1995 without ever having been implemented (Finance Minister - Avraham Shochat).

l 2000 - Ben-Bassat report. Comprehensive reform that set a uniform tax of 25 percent on all types of financial assets and investment instruments. Never implemented (Finance Minister - Avraham Shochat).

l 2002 - Rabinovitch Commission. Tax Reform Law passed by the Knesset, August 2002. Reforms to be implemented as of January 2003 (Finance Minister - Silvan Shalom).

The article was written with the assistance of Zvi Stepak, CEO of Meitav Portfolio Management, and Yuval Cohen, who heads the capital market department at the Income Tax Commission.