Israel's Tax Authority Is Closing in on Firms Using Tax Shelters

Efrat Neuman
Efrat Neuman
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Panama City
Panama City, a tax haven.Credit: Susana Gonzalez, Bloomberg
Efrat Neuman
Efrat Neuman

Two weeks ago, a dramatic bill initiated by the Israel Tax Authority quietly passed its first reading in the Knesset. If it becomes law, it could affect tens of thousands of companies under Israeli control that operate in tax havens, and is expected to expand the circle of those needing to file reports.

The bill represents the policy of the Tax Authority under Director Moshe Asher, who considers Israelis who exploit foreign tax havens as engaging in circumvention.

According to estimates, Israeli-owned companies operating in tax havens register as much as tens of billions of shekels in aggregate income. These companies are registered in tax havens where the tax rate is low to nonexistent – such as the British Virgin Islands, the Isle of Man, the Cayman Islands and the island of Jersey, as well as Cyprus, where the corporate tax rate is lower than in Israel.

The first part of the proposal relates to Israelis who operate through a foreign company and claim that control and management are not in Israel, so therefore the company is not obligated to pay corporate tax here.

In order to overcome these arguments, the proposal has decided on certain presumptions that will determine whether management and control are Israeli, with the burden of proof on the taxpayer.

The second part refers to Israelis who own a company that meets the definition of a “controlled foreign corporation” (CFC).

At present, this applies to a company operating in a tax haven, with most of its income defined as passive – for example, from interest or royalties. The controlling shareholder is required to pay a notional tax on his share of the profits from the passive income, as though they were distributed as a dividend (even if they weren’t actually distributed).

Under the proposed law, the Tax Authority expands the term “passive definition” to cases where the income is actually business-related, so the notional tax will be paid on it, too.

What is an Israeli company?

The Income Tax Ordinance states that a company is considered Israeli and must pay tax in Israel if it was incorporated in the country, or if the control and management of its business take place in Israel.

One of the authority’s objectives in the most recent Economic Arrangements Law (supplementary legislation to the budget) was to introduce an amendment making it difficult for companies to claim that the management and control take place outside of Israel. At a relatively early stage, the amendment was removed from the Arrangements Bill and it was agreed it would be submitted as a separate bill.

The bill determines the presumption that control and management of the company will be considered to be in Israel, unless proven otherwise. Although these presumptions can be contradicted by the company owners, the burden of proof will be imposed on the taxpayer – so the mere existence of the presumption involves an obligation to report in Israel.

There are three cumulative conditions for the existence of the presumption: The first is that Israeli residents own, directly or indirectly, over 50% of any type of the controlling stake in the company; second, that the company does not pay taxes of more than 15% in the country where it is registered; and third, one of the following conditions must exist – the company is registered in a country that has no tax treaty with Israel, or the company is registered in a country that does not impose a tax on income generated outside of it.

The presumption cannot only be challenged by the company’s owners but also by the Tax Authority.

An important part of the proposal states that if a company claims these presumptions do not apply to it, it is required to report this and support its position.

A significant part of the incentive for tax planning is not to be exposed to taxes at all in Israel, and most of the planning is based on the fact that the company receives an opinion stating that it is not required to pay tax in Israel – and so doesn’t report. This means that if the law passes, companies operating in tax shelters will be required to report to the Israel Tax Authority.

When control and management are not in Israel, the company can assume the status of a CFC. However, this is when Israeli residents own over 50%, directly or indirectly, of at least one of the means of control; less than 30% of its shares are traded (or not traded); most of its income in the tax year is passive income (for example, income from interest and linkage differences, dividends, royalties and rental fees); and the tax rate on the passive income in the foreign country is less than 15%.

This means that although the company won’t pay corporate tax in Israel, a controlling owner in a CFC with passive profits will be considered to have received his relative share of the profits as a dividend. In other words, the controlling owner is taxed at 30%, based on the company’s cumulative passive income, although he hasn’t actually received the money. That is a mechanism designed to transfer passive income to Israel – in other words, income that doesn’t require investment and management.

According to the bill’s explanatory notes, experience shows that many taxpayers classify the income of a foreign company under their control as income from a business, even if it comes from interest, linkage differences and leasing fees.

This is true, though we are discussing cases in which it would be proper, in terms of the purpose of the amendment, to consider this income passive and subject to the instructions of the amendment. That’s why there is a proposal to formulate clarifying rules in order to decide whether a specific income is passive.

No longer passive

In the current situation, the income won’t be considered passive in a case where, if it was produced or had increased in Israel, it would have been considered income from a business or profession. Under the new rules, the Tax Authority redefines cases in which even income from a business will, under certain circumstances, be considered passive income – according to the Tax Authority – in order to “seize” income that is essentially a return on capital.

According to the new rules, income from leasing will be considered passive – even if it is income from a business – if the asset was leased for over a year. The leasing period will be considered the maximum period stipulated by the leasing contract. In other words, even genuine income from a business will be considered artificially passive in a case of leasing for over a year.

Theimplications could be significant for a company with relatively large assets from leasing that were attained through bank financing based on working capital. If the bill becomes law, the owner of such a company would be required to pay a 30% tax on the profits from leasing – even if the company actually runs a business.

It was also decided that income from interest or linkage differences obtained from connected persons will be considered passive by definition. If it was obtained from unconnected persons, it will be considered passive only if it is not income that, had it grown or been acquired in Israel, would be considered income from a business or a profession, according to Israeli tax laws.

Regarding income from royalties (which are also relevant for Israelis who invest in mines), it was decided that the default definition would be as passive income, even if it is business income. The exception would be a case in which the royalties were paid for an asset that the recipient of royalties developed directly and the taxpayer is not connected to the recipient of the royalties.

The third part of the proposal falls into line with OECD recommendations regarding the taxation of multinationals. According to the bill, the Tax Authority can receive more information about multinational corporations operating in Israel and abroad.

In a case where the parent company is Israeli and its combined business turnover is over 750 million euros ($802 million), it will be required to provide an online report of all the financial and business data of all the companies in the group, and activity in every country during the tax year. The finance minister will be authorized to determine the data to be included in the report.

The bill’s explanatory notes state that the objective is to allow an analysis of the global activity of the Israeli company, in order to ensure that the price of the reported transactions reflects the market price and conditions.