Switch to Capital Gains Tax Encourages Profit Taking

The Income Tax authority has decided not to change the method for the transition between turnover tax, which has applied to financial market activity during 2003, and capital gains tax, which takes effect in January 2004. The decision means it will be financially advisable for many investors to take profits on stocks and mutual funds before the end of this year.

It is even possible investors interested in maintaining a certain security in their portfolios will benefit from selling the security before year-end and then re-purchasing it.

However, tax authorities could note transactions that appear artificial - such as the selling and buying of an entire securities portfolio on the same day - and could charge full capital gains tax on them. Graduated implementation will not be considered an artificial transaction.

The odd situation is created by 2003's categorization as a transition year in the implementation of the tax reform, during which the banks are charging 1 percent turnover tax on securities sales. Starting in January 2004, however, the banks will charge a 15 percent tax on the capital gains. The relatively sharp gains seen on the Tel Aviv Stock Exchange in 2003 - the TA-100 index has gained 37 percent while technology stocks have climbed an astounding 85 percent - has meant that those who hold many stocks will pay substantially less tax under the turnover tax method than in the form of capital gains tax.

The profits from a securities sale can be quite high. For instance, an investor who picked up NIS 10,000 in shares in Alvarion in early 2003 can now sell them for NIS 35,000. Alvarion's per share price has climbed this year from NIS 9 to NIS 31.9. Turnover tax would amount to NIS 350 if the transaction closes before the end of the year. After January 1, capital gains tax will amount to NIS 3,750.

Players Sunday avoided speculating on how the market will respond as investors realize it is preferable to sell securities before the end of 2003. Some did comment that it is possible turnover will increase substantially and there could be pressure on some stocks.

Another income tax issue that has arisen lately is the question of inflation adjustment. According to the reform, capital gains tax on stocks and mutual funds is real. This means the consideration for the purchase or sale must be linked to the known consumer price index at the transaction date and deduct the inflation-induced loss to the investor. The tax must then be paid as 15 percent of the remaining profit. Under normal conditions in which inflation exists, even low inflation, real profits will be lower than nominal profits.

However, due to the negative inflation rate projected for 2003, inflation adjustment will result in real profits that are higher than nominal profits. The market is concerned this will mean the tax will be greater than 15 percent. Income tax officials have said that in the event of deflation, the inflation link will be waved and the tax will be calculated on a purely nominal basis.