The Tax on Captive Profits: Penny Wise and Pound Foolish

In a hurry to help close a massive budget deficit, the government is offering some of Israel's biggest companies a massive tax break.

The Knesset Finance Committee will convene next week to ratify a decision by the Finance Ministry on how to deal with so-called "captive profits." This will assist the ministry in a one-time attempt to collect NIS 3 billion in taxes, desperately needed to partially close a huge gap in the 2012 budget.

This pot of money was created over the last decade as a result of tax incentives given to companies investing in development in Israel's periphery. Over the years, a small number of corporations amassed huge profits, which by law could not be transferred abroad - hence the term captive.

The Income Tax Authority estimates these profits at NIS 120 billion, made by roughly 2,000 companies. However, most profits were actually made by four of the largest corporations. Between 2003 and 2010, Teva, Check Point, Israel Chemicals and Intel accumulated 50% of these profits, with 1,900 other companies accounting for another 25%.

Thus, after fulfilling their obligation by investing in outlying areas, these companies enjoyed almost total tax exemption on profits made from their activities in Israel. This was clearly not the intention of the lawmaker, and is illogical as well as exceedingly unjust.

A glaring example is the gigantic drug company Teva, Pharmaceutical Industries which pays no corporate tax in Israel while accumulating billions of tax-free shekels a year. This is expected to continue in future years. The staggering figure of NIS 2.5 billion in tax exemptions in 2010 amounts to more than 150% of all wages paid by the company.

Steinitz's modest proposal

In view of this rich potential source of income, and in the face of an enormous shortfall in revenues in the unbalanced 2012 budget, Finance Minister Yuval Steinitz has come up with a novel proposal. He will offer companies such as Teva a 5% tax, projected to yield NIS 3 billion in revenues, in exchange for a pardon on taxing any outstanding amounts.

This pardon would relinquish tens of billions of shekels in tax revenues. Despite much opposition, the Steinitz plan has been approved by the cabinet and Knesset plenary, and requires only final approval by the Finance Committee.

Members of the committee should know there are two fundamental problems with this proposal. First of all, it is unclear whether these companies will accept the offer. In feelers sent out to some companies by Income Tax Authority accountants, there were some positive responses, although other companies were opposed to any retroactive changes in legislation.

The other problem is one of principle. Under pressure, the Finance Minister is giving up the state's obligation to try and extract the maximal amount of taxes owed by big corporations. These companies have benefited from years of paying negligible taxes, and are now being offered another huge break.

By right, this offer should be made to all taxpayers, companies and private citizens. There are currently NIS 20-30 billion in unpaid taxes in Israel, according to the tax authorities. One can assume that if these large companies accept the deal, it will be good for them and thus bad for the national coffers. This is a zero-sum game.

Why doesn't the minister offer a sweeping national pardon, even if only a partial one?

The answer appears to be a legal one. To facilitate such a move and collect larger amounts in back taxes as well as higher taxes on future profits, the Finance Ministry will need to bring to court strong legal arguments and novel tax interpretations. Failing that, new legislation with aggressive new tax rates will be required.

It is unclear how the courts will rule. Steinitz also knows that facing him will be some of the best lawyers and accountants in the country, leading to a very drawn-out process. No revenues will be collected for years, and Steinitz needs the funds now.

Social justice is certainly not part of the proposed deal. Close examination of the details reveals that it is tailor-made for Teva, a company which already benefits from an earlier law passed to accord with its particular needs, the Israeli patents law.

Teva is the largest manufacturer of generic drugs in the world. It operates by challenging the patents of leading global drug companies, based on local laws in different countries.

It is no coincidence that countries such as the United States take issue with Israel over its patent laws. The current new tax proposal could be termed the second "Teva" law, which will enable the company to continue operations for many years, enjoying tax exemptions or negligible tax rates. What will happen if the ministry decides to go to court and fails in an attempt to extract the full amount of taxes owed?

The state can change tax policy

The ruling of the Sheshinski Committee, which dealt with taxing oil and gas revenues, showed that changing policy is possible, both morally and legally.

The state is allowed to change tax regulations if it turns out that some companies benefit from unfair advantages, not concordant with the lawmakers' intent or with fair competition. In addition, the Steinitz proposal is not a case of finding a compromise between companies or individuals.

Just as the authorities try to collect every shekel owed by regular taxpayers, they should do their utmost to collect the maximal amount from powerful corporations. Even if it loses in court, the Finance Ministry should do the right thing and try. It can always learn from a possible defeat and search for other legislative solutions.

Another clause in the Steinitz plan for filling in the budget gap is puzzling. The plan is to increase revenues by NIS 2 billion by enhancing tax collection through combating the underground economy. Everyone recognizes that not much will be achieved by chasing plumbers who neglect to hand out receipts, and that the big money lies in fair taxation of the large corporations.

As with all other cases of social injustice, the main issue is whether and when the government will decide to tackle the big and powerful corporations that control finances and wield enormous political clout in Israel, instead of continuing to milk the middle class as well as small and mid-size companies.