U.S. Tax Reform May Cause Israel to Drop Key Investment Law

National Economic Council proposes controversial measure amid concern over an exodus of American and Israeli companies

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Prime Minister Benjamin Netanyahu at an Intel factory in Kiryat Gat, Israel, 2017.
Prime Minister Benjamin Netanyahu at an Intel factory in Kiryat Gat, Israel, 2017.Credit: Kobi Gideon / GPO

Israel is weighing elimination of the key part of its industrial policy as it grapples with ways to prevent U.S. tax reforms from causing an exodus of American and Israeli companies from Israel.

Prof. Avi Simhon, who heads Prime Minister Benjamin Netanyahu’s National Economic Council, is proposing to replace the Law for Encouraging Capital Investment with a regime that give tax benefits to companies conducting research and development in Israel.

Simhon, however, is encountering resistance from elsewhere in the government, as officials are still at odds over the best way to deal with the problem, which arose when Congress approved a sweeping tax overhaul last December, which, among other things, lowers the corporate rate to 21% from 35%.

The investment law, which awards either grants or tax benefits to companies that generate jobs and exports in Israel, has for decades has been the centerpiece of Israeli industrial policy.

But the law has come under criticism for failing to meet its goals, especially in Israel’s periphery where the incentives are the strongest. It came under especially heavy criticism after an amended version ended up inadvertently giving big companies billions of shekels of tax breaks.

The problem has since been corrected, but critics, including Simhon, say it fails to exploit Israel’s competitive advantage, which is in innovation and R&D. Simhon and others contend that with Israel’s limited budget resources, it can’t afford to be subsidizing investment both in capital-intensive manufacturing and R&D, so it should target its resources to get the best results.

The economic council was given a mandate to look into the problem of the investment law earlier this year after the government approved the so-called Industrial Net program, which is aimed at improving the competitiveness of Israeli companies, especially in older, non-tech industries.

More recently Netanyahu instructed the council to devise a strategy for coping with the U.S. tax overhaul. Among other things, the reform will require American companies with operations in Israel to pay more U.S. tax regardless of what Israeli tax rates are.

However, the council isn’t alone is trying to formulate a policy. Israel’s treasury and its Economy and Industry Ministry are working on proposals of their own – and the latter isn’t entirely in agreement with the economic council.

Both sides say R&D should be the basis for any new policy on tax benefits. But the Economy Ministry has adopted the view of the Israel Innovation Authority, which wants to give the breaks to small and medium-sized companies, especially in older industries, rather than the giants that have benefited from tax breaks until now. It opposes doing away with the investments law.

Smaller companies in Israel tend to be less globally competitive and don’t spend enough on R&D. The ministry proposes giving them tax benefits based on incremental sales generated by R&D. The economic council, for its part, wants to make the R&D benefits universally, including for big companies, like Check Point Software. But it wants to condition that on rescinding the investment law.

That council’s proposal also takes into account the U.S. tax reform. It’s the biggest companies, including Israeli ones like Teva Pharmaceuticals and U.S. companies like Intel, that may move manufacturing operations out of Israel to America to keep their lax bills down.

That means that any R&D tax break will have to be conditioned on companies not just conducting research in Israel but manufacturing as well.

Economy Minister Eli Cohen has his own package of proposals to cope with the tax gauntlet thrown down by the Americans. Last week his ministry proposed five options for dealing with it. In addition to the R&D benefits, they include canceling a 4% dividend tax that Israeli law imposes under the investments law. The new American reforms will no longer allow U.S. companies to deduct the cost of the tax.

Another proposal calls for accelerated depreciation on capital equipment so that all expenses are recognized in the first year. The U.S. reforms don’t allow American companies to deduct preliminary tax payments, so the Economy Ministry proposes doing away with them and raising the lower corporate tax rate under the investment law to 10% from 7%.

Another measure seeks to counter the impact of the so-called Base Erosion and Anti-Abuse Tax, or BEAT, which slaps a 10% tax on imported services to the U.S., including by foreign companies. That could cause a lot of Israeli companies, especially startups, to incorporate in the U.S. To prevent that, the Economy Ministry proposes allowing companies to deduct their BEAT payments against Israeli tax.