The profits of a controlled foreign company (CFC) that constitute the basis for a deemed dividend are derived, in the case of treaty countries, from the tax law in that country, according to the definition of the “Applying Tax Laws”. This definition was changed within Amendment 198 to the Income Tax Ordinance (ITO), effective from the 2014 tax year, within which it was stated (inter alia) that deemed expenses that are not recognized in the generally accepted accounting principles (such as deemed interest) are to be neutralized. The purpose that the legislator intended to achieve in that amendment is equalizing the profits of the company that enjoyed such a beneficial tax regime to those that would have been determined had it not been calculated under that beneficial regime, and thus make those profits consistent with the accounting or cash flow profits that were actually distributable as dividends to the shareholders. For example, such a company whose passive profits are 100, but was entitled to a total of 80 as a deemed interest expense for tax purposes in that country (despite such expense not having paid and not due to be paid ever in the future), will be able to distribute an actual dividend of 100 rather than just 20, and therefore the neutralization stated above achieves the desired effect. Conversely, it is known that many countries have restrictions and limitations concerning the deductible financing expenses. Sometimes the limitations relate to loans from related parties and sometimes to all financing expenses of the company, usually it is a case of a permanent difference. Usually these are thin capitalization rules within which interest will be deductible to the extent that a specified equity-debt ratio is obtained. In recent years, instead of or in addition to these rules, many countries impose additional restrictions, such as: setting a limit for deductible interest expenses as a percentage of EBITDA, or setting a limit to the interest rate that may be determined for a loan to a related party. One may ask how such genuine financing expenses (that have been actually paid) that were not deductible in the (treaty) country of residence by the company that is classified in Israel as a CFC are being taken into account. Meaning, further to the example given above, we assume that the profits of the company are 100, and it has actually paid interest at the amount of 80 to a local bank from which it took a loan. Within the company’s tax return only 30 out of 80 was a deductible expense. The profits of the company in that year, for accounting and cash flow purposes, total at 20, and this is the amount that it may distribute as a dividend to its shareholders.
However, according to the “Applying Tax Laws” definition, the profit to which the CFC provisions will apply is 70 (100- 30), that is the taxable income in that country.
In our opinion, in such cases, the CFC provisions of the ITO should be interpreted according to their purpose and a controlling shareholder of a CFC should be taxed merely on the profit that he could have received as a dividend (in the example above – 20), because in the current legal situation described, the controlling shareholder is taxed on incomes that he and/or the company have not received and will not actually receive. The distortion is worse when the interest expenses that were not deductible by the company are those paid to the controlling shareholder himself, meaning that in Israel the controlling shareholder is taxed twice for that income amount that was not deductible by the company (in the example above – 50), firstly as actual interest incomes and secondly as a deemed dividend (under the CFC provisions).