Tax Alert No. 1 - 21.3.2008

On March 13, 2008 the Israeli Ministry of Finance issued an official press release according to which significant legal amendments and benefits are planned to be introduced in relation to the 60th anniversary of the State of Israel.

The plan includes tax amendments to be enacted as a tax reform aimed, according to the Finance Minister, to encourage former Israeli residents and new immigrants (or “Olim“) to reside in Israel. This planned tax reform is coordinated with the Israeli Ministry of Immigrant Absorption.

Currently, the Israeli Income Tax Ordinance (“ITO“) provides certain tax benefits to New Immigrants as well as to former Israeli residents who returned to Israel (“Returning Residents“). Significant amendments to the current tax benefits include the following:

• Currently under Israeli tax law, a 5-year tax exemption may be provided on passive income (i.e., income from dividends, interest, royalties, rent/lease and annuities) related to assets acquired abroad by New Immigrants and a 10-year exemption on capital gains related to such assets. In addition, a 4-year tax exemption on business income (if sourced from a “business”, which was established during the 5-year period, prior to immigrating to Israel) is provided.
• According to the contemplated reform, the above mentioned tax benefits provided to Olim, will be replaced by a strict 10-year tax exemption with respect to any gains and income. Income and gains for the purposes of the reform are expected to include any class of income/gains from sources outside Israel, including fees/income from personal occupation, and employment income instead of passive income and gains only as currently applies;
• Cancellation of the requirement to report to the Israeli Tax Authorities (“ITA“) with respect to such exempted income or gains;
• According to the Management and Control Principle, a non-Israeli resident company, although established outside Israel, may still be considered as an Israeli tax resident if it is “managed and controlled” from Israel. However, the applicability of this principle is suggested to be annulled with respect to companies that have been managed and controlled from Israel by New Immigrants prior to their immigration to Israel;
• Returning Residents who resided outside Israel for more than 10 years, and return to Israel are expected to be provided with a new “tax status” (“A Returning Resident which is classified as a New Immigrant for Income Tax Purposes“). Returning Residents who will meet the related legal requirements may actually enjoy equal benefits related to their income and gains, as those provided to Olim.  A Transition Provision is suggested for enactment, according to which in 2008 and 2009, Returning Residents will be eligible for the said tax status if they resided abroad for 5 years (instead of 10), provided that they were non-Israeli residents on January 1, 2008 (Currently, Returning Residents enjoy a 5-year exemption on a certain passive income if they were non-residents for only 3 years). As for the 10-year period requirement for these Returning Residents, the following may ensue: If the year of “departure” and the year of “return” are included in this 10-year period, it may be possible that, in some cases, the actual residency outside Israel may effectively be limited to approximately 8-years;
• In addition, a one-year “adaptation period” will be introduced. Accordingly, individuals who immigrate to Israel may retroactively elect, not to be considered as Israeli tax residents during this period, in order to allow them to decide whether they would actually opt to reside in Israel and to be classified as Israeli residents for income tax purposes.

Following this formal announcement, it seems that the scope of current tax benefits would be significantly extended.

However, it should be emphasized that, at this point, the information provided by this press release is very general and lacks legal characteristics. It only gives a general idea with respect to the contemplated tax reform, but it triggers significant questions as for the applicability of such provisions. Therefore, tax practitioners in Israel expect for the actual wording of a draft law to be presented by the Israeli Parliament.

In our view, this contemplated tax reform reflects a new and exceptionally liberal Israeli policy towards Olim and Returning Residents in order to encourage them and to ease their possible transition to Israel. It is, therefore, appropriate that the Israeli Tax Authority follows this direction while implementing the reform in the future while exercising its discretion with respect to specific cases. As a result, it is expected that:

•  The eligibility for the said benefits should be implemented according to tax residency provisions in tax treaties concluded by Israel and not according to Israel’s domestic law;
•  The period of foreign residency for former Israeli residents should start on the day they left Israel permanently (assuming this was their intention) and not one or even two years after they actually left Israel, as it has may some times occur.

In November 2007, a significant tax Decision (Income Tax Appeal 1226/02) was issued by the Tel Aviv District Court. According to that Decision, dividend stripping, i.e., the transfer of shares of a company immediately prior to dividends distribution, should be considered as two separate transactions, for tax purposes: (a) transfer of shares; and (b) the right to receive dividend income on a specific day.

The Israeli tax implications on non-Israeli residents may be significant, mainly with respect to the determination of the jurisdiction of source for capital gains purposes.

(a) Transfer of Shares – In case a non-Israeli resident sells shares in an Israeli resident company (or shares of non-Israeli resident company where most of its assets are located in Israel) the Israeli tax implications are clear – since the sold asset is located in Israel for Israeli tax purposes, according to the ITO (Section 89(b)), Israel may impose its taxing rights on such gains sourced in its territory.

 (b) Transfer of right to receive dividend income – according to Israeli tax law, in determining the source of dividend income, the jurisdiction of the distributing company will also be regarded as the source jurisdiction of the dividends. Accordingly, in case the relevant company is a non-Israeli resident company that mainly holds assets or real-estate in Israel, the sale of its shares by a non-Israeli resident will be regarded as a sale of asset located in Israel and Israel may exercise its taxing right, but as for the right to receive dividends, the source jurisdiction would be in such company’s state of residence and Israel may not tax such right for dividends.

It should be noted that gains related to such a right to receive dividend may be classified as gains from the alienation of “other” property, according to most of Israel’s tax treaties and the taxing right would exclusively be of the “state of residence of the alienator”, i.e., outside Israel.

General

As a general rule, tax treaties provisions should prevail over the domestic laws of the contracting states.

According to a landmark decision of the Tel-Aviv District Court (the 5663/2007 the Yanco-Weis Decision), Israeli domestic law provisions, which are designed to prevent tax abuse and tax evasion, should also apply to tax treaties concluded by Israel, since the domestic law provisions “merge” or combine with the applicable treaty provisions. In addition, a reliance on tax treaty provisions should be performed in order to prevent double taxation and not for abusive purposes. Any treaty should be interpreted in good faith, as this fundamental term is used in the legal world.
The intention of treaty parties should be interpreted in light of the current sophisticated tax planning business world.

The Dispute

In that case, a company that was established under Israeli law has “migrated” to Belgium (a Belgian Certificate of Fiscal Residency was provided). The ITA argued that, according to Section 86 of the ITO (dealing with artificial transactions), this “migration” was motivated solely by illegitimate tax abuse purposes and not by any business purposes. It is therefore a sham transfer of residency. In addition, the company has been managed and controlled from Israel and most of its income is from Israeli sources. Therefore, the company should be classified as an Israeli tax resident according to the ITA. The company’s position was that according to the Israel – Belgium Tax Treaty, it should be regarded as a Belgian tax resident, no anti-abuse provisions are included in the Treaty and a reference to Israeli domestic anti-abuse provisions is prohibited since only “treaty-level” provisions should apply.

The Tel Aviv Court’s Decision

A limitation of benefit clause, according to the standards of the Israeli domestic law as well as the international law, should be read into the texts of treaties for the avoidance of double taxation, which were concluded by Israel, in cases where treaty abuse is evidenced and proved and also in cases where treaties do not include anti-abuse provisions.

As for the evidential threshold required in order to establish an “abuse”, the court refers to the OECD Commentaries: “Whilst these rules do not conflict with tax conventions, there is agreement that Member countries should carefully observe the specific obligations enshrined in tax treaties to relieve double taxation as long as there is no clear evidence that the treaties are being abused.”
According to the Court, treaty benefits apply only where the taxpayer operates in good faith.

The domestic anti-abuse provisions combine with relevant treaty provisions. A tax treaty is designed to prevent double taxation and not for abusive purposes. The fundamental legal concept of good faith hould also apply while referring to tax treaties benefits, ased on the precise wording of Article 31 of the Vienna Convention on the Law of Treaties. The intention of treaty parties should be interpreted in light of the current sophisticated tax planning business world.

Possible Implications of the Decision

Complicated tax structuring, in cases where business motivation may not be the main motivation, could put shareholders and investors in a problematic situation from an Israeli tax law perspective.

Other anti-abuse provisions in the Israeli Domestic Law may also apply. This may affect due diligence processes related to Israeli public as well as private companies.

Specific Israeli tax planning issues, such as the election of specific jurisdictions for holding purposes, management and control or inter-group transactions, should cautiously and wisely be organized and performed.