A Guide to the Tax Reform, Made Simple

Yesterday, a new tax regime for the Israeli stock investor came into force. As a result, the Tel Aviv Stock Exchange closed for the day, in an unprecedented move, to allow banks and brokers to adjust their portfolio records in line with the new tax system.

In general, the tax reform came into force on January 1, 2003 in three phases.

l For the first year only, a turnover tax was imposed on gains from stocks and mutual funds.

l As of yesterday, the turnover tax was replaced by a true capital gains tax, applicable to most of the securities traded on the Tel Aviv Stock Exchange. Until now, gains from bonds had been exempt from tax, but that exemption ended yesterday.

l The third phase kicks in on January 1, 2005, when the tax rate for gains on foreign securities, now 35 percent, will be equal to the 15 percent rate for gains on Israeli securities. As things stand, Israeli securities are protected by the unequal tax.

Let us look at some key terms in the tax reform.

l Virtual portfolio sale: That was this week's red-hot topic. The Income Tax Authority decided to allow investors to "virtually" sell and repurchase all their tax-liable securities by the end of 2003, and to pay a turnover tax on the virtual turnover. The banks even set up special software to handle these virtual sales, so they did not artificially skew the Tel Aviv Stock Exchange figures during the final days of the year.

The whole concept was created to stop the flood of tax-dodging sales that had begun to take place. Last year was a boom year on the TASE. If investors were to pay capital gains tax on all their gains from the real original purchase date, they could take a huge hit. As a result, many actually started selling their securities and buying them back, paying turnover tax in 2003, in order to begin 2004 from a higher pricing level. The tax authority's decision to allow for virtual sales legitimized such dodging in order to prevent shocks in the market.

l Turnover tax: A 1 percent tax payable when selling liable securities in the second half of 2003. Turnover tax had been only 0.5 percent in the first half of the year.

l Capital gains tax: A 15 percent tax on real profits from the sale of Israeli stocks, CPI-linked bonds and so-called "mixed" or "exempt" holdings in mutual funds. The tax is only 10 percent on gains from shekel investments (deposits, shekel-denominated bonds).

l Gaining from losses: If, after January 1, 2004, you sell stocks on which you have lost money, you won't pay any tax at all, because the applicable tax will be on capital gains, which you don't have. Moreover, your loss can be offset from gains you make on other securities in 2004.

l When the bite lands: Capital gains tax applies when you sell. The charge for dividends, or interest, will be levied only when you receive the actual payment. Tax on savings or deposits will be levied when you redeem. Theoretical gains are not taxable, nor can theoretical losses be used to offset gains.

l The May 2000 barrier: For historical reasons, the law differentiates between bonds and savings issued before May 2000 and ones issued afterward. Government, corporate or convertible bonds issued before May 2000 will remain subject to the tax regime that applied before May 2000. Linked bonds issued after May 2000 will be liable to 15 percent capital gains tax on the interest and capital gain, while shekel-denominated bonds will be liable for 10 percent tax.

l Offsetting losses: Losses incurred on securities can be offset from gains on other securities, without a time limit. Meaning, you can transfer nominal losses from year to year. One problem is that if inflation rears its ugly head, your losses would erode.

One problem with this mechanism is that at this stage, at least until tax on Israeli and foreign securities is equated, there is a whole range of offsetting options. But you can't offset losses on foreign securities from gains on local ones. Nor can you offset capital losses from gains on interest or dividends. You can, however, offset capital losses from mutual funds on gains from interest and dividends.

l Filing tax returns: The tax reform committee ultimately decided against forcing the entire population to file tax returns. Instead, it ordered the banks to collect the applicable tax when the customer sells and to report such transactions to the Income Tax Authority.

l Original and adjusted purchase prices: Capital gains tax is calculated by deducting the sales price from the original buying price and multiplying by the rate of tax (10 percent or 15 percent).

The original buying price is what you paid, adjusted to the consumer price index, or the price of the share in the last three trading days of 2003, whichever is higher.

l Negative CPI: The reform does not acknowledge a negative CPI. When inflation falls, therefore, real gains increase and so does the derivative tax bite. But Deputy Income Tax Commissioner Oskar Aburazak has said in the past that tax will not be charged due to negative CPI figures, meaning, the change in the real price shall be considered the nominal gain.

l Offsetting losses generated before 2003: Major losses on stocks or mutual funds accrued before 2003 cannot be offset from gains on other securities. But you can retain a stock on which you incurred losses until it reaches the adjusted sale price, sell it, and avoid tax.

l Tax-liable mutual funds: These are funds that themselves pay tax on capital gains, interest and dividends. The liable tax is the same that ordinary taxpayers would owe: 15 percent on shares, 10 percent on shekel bonds, 35 percent on foreign securities, and so forth. When selling holdings, the depositor does not pay a penny in tax. But you can't offset losses incurred on one of these mutual funds from other gains, as the fund does so itself.

During 2003, most of the shekel and bond-oriented mutual funds decided to choose the classification of tax-liable mutual funds.

l "Mixed" mutual funds: These are funds that are exempt from capital gains tax but owe partial tax on dividends and foreign securities. You pay 15 percent capital gains tax on such funds. Tax on dividends runs at 12 percent, while on foreign securities it is 24 percent. So when you pay the 15 percent capital gains tax, you are completing the 35 percent bite on foreign securities and 25 percent tax on dividends.

Mixed funds confer certain advantages. One is tax deferral, in which depositors can delay tax for years if they keep their holdings. Another is that they can offset losses or gains from other securities, which is not the case for holdings in tax-liable mutual funds.

l "Exempt" mutual funds: The fund pays no tax on capital gains, interest or dividends. When divesting, the investor owes 25 percent on his real gains. These funds are designed to serve corporations and institutional investors, not individuals. But losses from other securities can be offset. They are also well positioned to invest in foreign securities.

It's all in the numbers

0% - Tax applied to gains from foreign currency investments. That renders the dollar and euro as the only investment exempt from tax.

0.2% - The commission banks charged for handling "virtual portfolio sales."

1% - Turnover tax withdrawn when selling shares and holdings in "mixed" mutual funds during 2003, as well as tax on virtual portfolio sales.

10% - Tax on gains from shekel assets - deposits, bonds. To be calculated in nominal terms, irrespective of inflation.

12% - Tax applicable to "mixed" mutual funds, on dividends.

15% - The most prevalent tax rate. Applicable to real capital gains from shares, mixed mutual funds, linked bonds and savings. Calculated by the compensation upon sale minus the indexed cost of purchase, multiplied by 15.

24% - Tax that mixed mutual funds pay on foreign securities.

25% - Tax on capital gains made from "exempt" funds. Also the tax on dividends.

35% - Tax on gains from foreign securities.