The Israel Tax Authority celebrated a victory on Tuesday. As of last weekend. it had only collected NIS 1 billion under the “trapped profits” law and its goal of reaching NIS 3 billion seemed out of reach. But a resolute campaign of pressure by the authority has paid off and all the relevant top exporting companies have paid up. A total of NIS 4.4 billion has been collected – nearly 50% beyond its target.
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It’s been a long time since the tax authority surpassed a collection goal it set for itself by 50%, so the gushing is understandable. But the authority's self-congratulations are less understandable when looking at the underlying figures of the law, which deals with undistributed – and therefore untaxed – profits amounting to NIS 122 billion.
The State Comptroller estimated the taxes that should have been payable on these profits at NIS 21 billion, while other estimates put the figure closer to NIS 17 billion. Either way, the NIS 4.4 billion collected represents just 20% to 25% of the potential – a miserable failure, rather than a cause for celebration - and one whose lesson has not been sufficiently absorbed.
The opinion written Deputy Attorney-General Avi Licht on the tax authority's decades-long legal stance on taxing trapped profits says it all; what is now being celebrated as an achievement is tantamount to the authority's own Yom Kippur War. The State Comptroller’s report on the tax authority’s approach to the legislation bears the same message: It was an ongoing failure, in which nearly every possible professional blunder was committed. The final mistake was the trapped profits law itself.
The basic blunder was, of course, the old Encouragement of Capital Investments Law, which allowed companies to invest tax-free as long as profits from those investments were reinvested in Israel. Any other use of those profits should have been declared a taxable use, for which the law set three tax rates – 10%, 15%, and 20%. The law was so complicated that only the largest companies with the deepest pockets could unscramble and take advantage of it, so, right from the start, it was destined to benefit large companies at the expense of smaller businesses. It was worded so carelessly and vaguely that large companies, well-armed with legal opinions, could interpret it as they wished.
Companies presumably refrained from using the profits (hence the term “trapped profits”) to avoid having them taxed. But, in fact, those profits were heavily utilized, without being subjected to taxes. In some cases, companies used the money to invest in subsidiaries abroad, on the pretext that these investments contributed to the company’s earnings in Israel – no different from for investments within Israel. Teva Pharmaceutical Industries, which according to the tax authority invested about NIS 21 billion from its trapped profits in foreign companies, used this exact argument in court.
The sloppy wording of the old law was the root of all evil, but two more severe misdeeds were later committed. One was expanding the law’s scope in 2005, by removing any limits on the extent of tax-free profits. This turned the messy law into a macro-economic disaster, with trapped profits ballooning to a monstrous NIS 122 billion.
The second transgression was when the tax authority decided to adopt the interpretation of the law held by Teva and like-minded companies – that investments in foreign subsidiaries from trapped profits are tax exempt.
Interestingly, there is no official opinion paper by the tax authority supporting this position. In other words, the authority never formulated an official professional stance on the question of whether investments in foreign subsidiaries are indeed tax exempt. But somehow the opinion expressed in 2005 by one former tax authority official in front of the Knesset’s Finance Committee took root and nobody at the authority dared question it – at least until the trapped profits law passed last year when, for the first time, the state was asked to legally reexamine this approach.
Licht’s legal opinion stated that this was a fundamentally flawed approach and that investments in foreign subsidiaries are subject to tax. But, rather than grabbing at this opinion as its legal basis for assessing taxes on an estimated NIS 40 billion in trapped profits (the sum believed by the tax authority to have been invested in foreign subsidiaries.) the State Comptroller describes how the top brass at the tax authority besieged Licht with demands that he change his opinion. One of their dubious arguments was that, since throughout the years they had already given in to the companies and didn’t charge tax for diverting trapped profits towards investing in foreign subsidiaries, they couldn’t suddenly go and change their minds.
Licht succumbed to the pressure, and this brought about the final tragic mistake – the trapped profits law itself. The law assumed the situation to be irreversible and that taxes on NIS 122 billion in trapped profits couldn’t be collected. It therefore deemed it better to entice companies with a 60% discount on the taxes they should have paid – Teva, for example, paid at a rate of 6% rather than 15% - just so they’d do a favor and pay part of their taxes.
The large companies apparently mulled it over, and at the last minute made a gesture to the state by agreeing to pay the reduced amount. But perhaps they really had nothing to really mull over, since it was mainly the state doing the companies a favor. This is because the law provided a tax discount on nearly all the trapped profits, including those that could have been challenged in court with the backing of Licht’s legal opinion or already the subject of claims submitted in court, as well as profits for which assessments had already been sent out.
Teva, for instance, was sued by the state to pay taxes amounting to NIS 3.4 billion for 2005 to 2007 alone and its maximum exposure could have reached NIS 5 billion – 15% on NIS 33 billion in trapped profits. Under the trapped profits law, the company ended up paying the state just NIS 2 billion on the same amount. In other words Teva saved itself the risk of paying NIS 1.4 billion to NIS 3 billion in taxes, and at the same opportunity closed other tax disputes with the authorities, while being touted as having “paid its debt to society.”
Just as it can’t be denied that Teva stood the risk of paying NIS 5 billion in taxes and saved itself NIS 1.4 billion to NIS 3 billion, the state could very well have lost its case and not seen a penny of the NIS 2 billion that Teva ultimately paid. Both sides, therefore, performed their risk calculations. But while Teva calculated its risks intelligently, the state basically took a wild stab at it.
Simply put, the state didn’t even attempt to ascertain the court’s position on the claim that investments in foreign subsidiaries are subject to tax, but threw in the towel and closed out all its assessments and court claims with the compromise trapped profits law. Over time, the state’s sloppy behavior throughout resulted in a defeatist attitude which played right into the hands of the country’s mightiest companies.
What can be done to make sure it doesn’t happen again? It’s doubtful the tax authority performed any analysis of the lessons to be learned. It’s too busy gloating.