Israel’s Tax Authority Has Lost Its Bite

Why should companies pay tax on so-called trapped profits when the tax authority has shown that it won’t go after them?

In a critique of the Encouragement of Capital Investments Law, the state comptroller cites a slew of numbers accompanied by charts. One interesting figure is the tax take on so-called trapped profits – corporate earnings that aren’t taxed because they haven’t been paid as dividends. The interesting figure is NIS 1 billion, just one-third the amount expected with less than a month to go before the law encouraging the repatriation of trapped profits expires.

This law has sparked an outcry, and rightfully so, because it tries to lure Israel’s largest companies into paying taxes by offering them a huge discount. In effect, the trapped-profits law turned a vital clause in the Encouragement of Capital Investments Law inside out.

The Encouragement of Capital Investments Law tries to motivate companies by threatening to tax profits used for anything but investing in Israel. The trapped-profits law suspended this threat by assuring companies that they can use their profits as they please in exchange for lower taxes.

According to the tax authority, exporters eligible for tax benefits under the Encouragement of Capital Investments Law accumulated NIS 125 billion in trapped profits between 1988 and 2010, of which only NIS 3.5 billion has been used, on which NIS 600 million has been paid in taxes. The remaining NIS 122 billion represents the trapped profits that the government wants to tap into.

These figures expose the absurdity in the Encouragement of Capital Investments Law. The law was designed to encourage companies to invest in Israel – but they didn’t. They either sat on the money, or worse, duped the tax authority by finding ways to use the cash elsewhere without paying tax.

How was this accomplished? Mainly by investing in subsidiaries abroad, claiming that the investment promotes the company’s operations in Israel, so it’s equivalent to investing here. As cited in the state comptroller’s report, about NIS 40 billion – nearly one-third of the trapped profits – was probably taken out of Israel this way with no tax being paid.

Double-faced

Why did the tax authority not tax investments in foreign subsidiaries over the years? The comptroller sheds some light on this. It turns out that tax assessments have been issued to companies improperly using trapped profits by investing in foreign subsidiaries, but these assessments were never acted on. This is “because the tax authority holds other views as well,” the state comptroller says.

The comptroller mentions comments in the Knesset in 2005 by a senior tax official, who said investing in a foreign subsidiary doesn’t violate the Encouragement of Capital Investments Law and isn’t taxable. Last year the tax authority stuck to the position that such investments are tax exempt.

In his report, the comptroller says Deputy Attorney General Avi Licht faced intense pressure while drafting his opinion that investments in foreign subsidiaries should be considered a violation of the Encouragement of Capital Investments Law.

According to the comptroller, “Just before the opinion was finalized, senior tax authority officials from the legal and professional departments approached the deputy attorney general claiming a problem in issuing tax assessments to companies that invested in subsidiaries or bought such companies since, among other things, the tax authority interpreted this issue differently over the years.”

Basically, the tax authority has been fighting on all fronts – with its own tax assessors and the deputy attorney general – to assert that investing in subsidiaries isn’t a violation of the law and that no taxes should be assessed on the NIS 40 billion invested abroad. The main argument is that the authority has kept mum all these years and can’t suddenly change its approach now. In other words, the authority is extending its incompetence into the future.

Licht, for one, didn’t cave to the tax authority. He ruled that investments in subsidiaries are taxable. But he did buckle by agreeing that the discount offered to companies under the new trapped-profits law also go to companies that invest in foreign subsidiaries.

The trapped-profits law was originally designed to let companies use these profits without paying full tax. But now the law has been broadened so that companies that have violated the law by using taxable profits can also enjoy the discount. Rather than using Licht’s opinion to collect taxes that should have been paid, the authority gave in and extended the discount to companies that owe full tax.

This brings us back to wondering why the trapped-profits law has only yielded NIS 1 billion. After all, shouldn’t companies be jumping at the huge discount offered? It only makes sense if we assume that the companies view the tax authority as a weakling. After all, companies caught using their profits to invest in foreign subsidiaries aren’t being asked to pay the tax due.

The tax authority’s complete lack of enforcement is the strongest explanation behind companies not accepting the discount. The tax authority chiefs should be losing sleep over this.

Lior Mizrahi