Analysis

Israel Racing With Ireland to the Tax Basement

The government is undertaking a far-reaching plan to attract global high-tech companies to Israel by reducing corporate tax rates to 6%, but is this going to benefit the economy? | Analysis

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The so-called stability clause – on the basis of which Israel’s government promises not to amend a piece of legislation for a certain period of time – received a bad rap during the fight over the gas framework agreement. Controversial as it was and rejected by the High Court of Justice, the idea of promising that a tax rate or regulatory reform will immune from any change by the government for a certain period of time wasn’t unprecedented: Its first problematic appearance was actually within the framework of the 2005 amendment to the Law for Encouraging Capital Investment, when several far-reaching tax benefits were created. The most extreme of these included a commitment to near-zero tax rates for major exporters, and a government promise not to alter them for a decade.

This commitment explains how Teva Pharmaceuticals became the biggest beneficiary of tax breaks in Israel, equal to 3.2 billion shekels ($837 million) in 2013 alone.

The seriously problematic nature of the 2005 amendment emerged relatively early, such that by 2011 – well before the Knesset woke up and started complaining about it – the government decided to rescind the stability clause. Thus, that provision was mostly, albeit not entirely, repealed that year as part of an amendment to the Law for Encouraging Capital Investment. However, one related stipulation remained, relating to the so-called “strategic” track that offers special benefits for companies the state deems as strategically critical for the economy.

The provision was meant to attract investments by global corporate giants with unusually attractiveunusually attractive incentives – but its preconditions are very tough. The incentives are a corporate income tax rate of just 5% for companies that build facilities in the periphery and 8% for those that do so in the center of the country, guaranteed for 10 years. That compares with rates of 9% and 16%, respectively, for companies not deemed strategic.

The preconditions, now in the process of being amended, are supposed to include a minimum turnover of 10 billion shekels ($2.62 billion) annually, out of which at least 1 billion shekels are exports. A corporate giant that meets these conditions – only Teva and the U.S. semiconductor maker Intel in Israel do right now – can ask to “join” the strategic track.

The uniqueness of this track is that the government is not obligated to accept any company that seeks the designation. . The applicant has to prove that it’s in Israel’s interests to give it the benefits – for example, by committing to investing or or creating jobs. In other words, the stability clause of the strategic track is a provision that stems from its contractual structure.

From this perspective, there is logic in this clause. Both sides are committed, not just the state. Moreover, such agreements are the norm in many countries, such as in the case of Ireland’s deal with Apple, which the European Commission deemed discriminatory and illegal.

Still, the problem with this stability clause is its lack of transparency. Three directors general – of the finance and economy ministries, and of the Israel Tax Authority – are empowered to make a decision on granting tax benefits worth billions of shekels. But there are no defined criteria for making the decision, and it is unclear whether such negotiations are proper or if there should be public disclosure of the agreement.

Door to corruption?

The stability clause has been on the books since 2011, yet no one has raised an eyebrow about it. In addition to the criticism it garnered during the gas framework debate, negotiations with Intel before it built its new factory also aroused members of Knesset and the Justice Ministry from their slumber.

Then this year the state came up with yet another stability clause-related amendment to the Law forEncouraging Capital Investment, which has yet to be approved. This time it addresses only high-tech companies that engage in significant research and development spending in Israel and offers them the possibility of registering the fruits of their R&D (i.e., intellectual property) in Israel in exchange for tax benefits. These would include a reduction in the corporate income taxe rate when they invest in the center of the country from 16% to 12%.

These companies would also be offered a type of task-oriented strategic track, open only to large corporations with a turnover of at least 10 billion shekels, whose tax burden would be lowered to 6%.

It seems that such a process is less attractive than the regular strategic track involving a 5% tax rate, but the new benefit would be offered around the country, including the center, where the strategic track only offers 8%. Because high-tech firms operate almost exclusively in the center, the new track is more attractive for them. Moreover, it offers multinationals another benefit: a dividend tax rate for foreign shareholders of just 4% (as opposed to the normal 20% rate).

This would be a very aggressive move, signaling to a great degree that Israel is competing with Ireland for the global high-tech business. Some will say it is a race to the bottom.

An additional innovation in the new track, which would be available to every giant high-tech corporation, without any strings attached, is that there is no need for approval by the three directors general. That would set a particularly problematic precedent, which would turn Israel into an especially convenient tax haven for high-tech giants.

But – and this is a big “but” – this latest amendment would be the third one in a decade. In light of the unstable reputation of Israeli tax policy, the temptation will probably not excite most multinationals, which assume that Israel will change tomorrow what it offers today.

Thus was born the new stability clause, which sticks with the 6% tax rate and says that a company that seeks that rate won’t need a green light from the three officials, or to prove it is transferring R&D operations worth at least half a billion shekels. Otherwise, the new amendment is similar to the current law. However, what passed quietly in 2011 is now encountering a wall of opposition in the Knesset and the Justice Ministry.

They started asking questions like, by what right do three directors general alone determine tax breaks worth tens of billions of shekels? Why are there no mandatory criteria for their decisions? Why is there no transparency? Is this not an open door to corruption, when so few people make such big decisions?

Misplaced suspicion

The suspicion surrounding this clause has surprised officials, who say it is misplaced. The three directors general do not function as individuals per se, but reflect the view of three government entities. Their decisions are based on professional work and the decisions must be made unanimously.

Negotiating with multinationals to incentivize them to invest in a country is a widespread practice in the developed world. Thus, this option must be kept flexible: Criteria should be adapted to the needs of each specific negotiation . Yet, it is this very flexibility that disturbs the Justice Ministry. It is unsure that the claim regarding limiting the discretion of the Knesset is in place. At stake is a type of contract between multinationals and the state, and it is problematic to expect a corporation to commit to huge investments without the state committing to something in return, especially when such negotiations are accepted when it comes to taxing multinationals elsewhere. Still, this is exactly what is worrisome. Does Israel really want to get in a race to the bottom of global taxation, especially with a country that gave a bad name to this race like Ireland?

If so, the questions about the stability clause – if it is proper to limit Knesset discretion (probably yes) and if it is proper that this step is made without transparence or criteria (probably not) – have both substance and legal importance. The questions concern why the current tax rates are insufficient, whether we have to strip before the multinationals to get them to come here, and what their benefit is to us if they barely pay any taxes. Indeed, the most bothersome matter is that the ones who will enjoy these benefits will probably be mainly Israeli companies, chief among them Teva.