As a rule, many Israeli companies are financed by shareholder loans. Interest that is paid to a shareholder, who is an individual, from a company that he owns (or that is held at a rate of at least 10%), is taxable at the marginal tax rate, according to the tax brackets of the shareholder (there is also the duty on the company to withhold the tax that applies in accordance with the maximum marginal tax rate, 48% today).
In view of this, the common choice in this type of financing is usually a linked shareholder loan (linked to the consumer price index or to any currency exchange rate) that does not bear interest (the linkage differentials or exchange rate differentials by an individual are usually tax exempt).

Recently, our office has encountered cases in which this manner of financing of an Israeli company is done, probably out of habit, even in cases where the shareholder granting the loan is a foreign resident (i.e. cases in which a foreign shareholder grants a loan to an Israeli company).
To the extent that this is not a treaty country, the choice above is correct because the tax liability applying to the shareholder and the duty to withhold the said taxes by the company, due to the interest, is the maximum tax rate, even in the case of a foreign resident.

However, to the extent that the state of residency of the shareholder is a treaty country, the limited withholding tax rate of the relevant tax treaty must be considered. For example, interest that is paid to a shareholder who is a French resident will be subject in Israel to a withholding tax at a rate of just 10% (out of the gross amount) and on the other hand will be deducted as an expense from the company’s income (subject to the rules applying to deduction of financing expenses).

Interest paid to a U.S. resident, for example, will be subject to a withholding tax at the rate of 17.5% of the gross amount or marginal tax on the profit from the interest (if the loan granter has expenses that may be deducted against the interest income), all according to the Israeli-U.S tax treaty.

Taxation at the rate of the marginal tax on net incomes (profits) is possible, in our position, even when it is not explicitly stated in the tax treaty.

It must be taken into consideration that in general the provisions of Section 85A of the ITO applies to such a loan received from a foreign resident (Section 85A of the ITO prescribes provisions regarding transfer pricing in international transactions) and market interest must be quoted. Usually, the ITA will not argue against a situation where the loan does not bear any interest, in the circumstances as described (particularly in the case of a profitable company or a shareholder from a treaty country), but it is certainly possible that in the residency country of a shareholder granting the loan, the local tax authority might exercise parallel provisions concerning transfer pricing rules and will charge the shareholder with tax on deemed interest income.
It would seem, against charging the shareholder for deemed interest income (in his country of residence), that it may be argued that a deemed interest expense at the company’s books should be permitted (despite these being two different countries and the tax charged on the interest income not being in Israel), inter alia in view of the approach that was taken in the Elisha court ruling (Civil Appeal 8131/06) in which it was ruled that the deposit that was made and held by the company generates deemed interest to the loan giver and grants deemed interest expense to the loan recipient at the same time. However, even under this analysis of deemed expense, without withholding tax at source for the foreign resident, this expense will not be permitted in view of the ITO’s provisions.

It is therefore advisable in these cases to specify market interest in shareholder loans that are made to the Israeli company by its foreign resident shareholder, particularly in the case of a treaty country residency.