Tax Alert No. 4 - 6.4.2009

Following the recent changes in Israeli tax legislation with respect to investments and business activities of non-Israeli residents in the Israeli market, we provide you with a brief summary of the general tax benefits and reliefs to non-residents in relation to selected issues:

Interest on Israeli deposit accounts in local currency – according to the current Israeli tax law, interest income arising through a deposit account of a foreign resident individual in an Israeli financial institution, would be subject to tax in a rate of 20%, provided that this is not his ordinary business activity. 15% tax rate applies in case the financial tool / asset is not indexed-linked (fully or even partly).

Interest on Israeli deposit accounts in foreign currency – according to the Income Tax Ordinance and specific regulations (“ITO“), an interest income arising in an Israeli deposit account which is held in Israel in a foreign currency of a “foreign resident” (i.e., not only an individual) shall be tax exempt, if certain conditions are met. These conditions include the following:

• the deposit is not (or shouldn’t be) registered in the books of an Israeli permanent establishment (“PE“) of a foreign resident and is not a business income or vocation income;
• there are no Israeli resident partners in the deposit account;
• the deposit is not used as a loan or to secure a loan provided by the financial institution to an Israeli resident who is “related” to the foreign resident.

Capital gains on non-traded securities – The ITO provides a tax exemption to non-residents on capital gains arising from non-traded securities and in case the gain is not of an Israeli PE of the foreign resident. The exemption does not apply to gains from the alienation of shares of a company, the property of which mainly consists (directly or indirectly) of immovable property situated inIsrael.

Capital gains on traded securities – The ITO provides tax exemption on capital gains from traded securities (in the Tel Aviv Stock exchange) in case the gain is not of an Israeli PE of the foreign resident.

Dividends from traded and non-traded Israeli securities – It should be emphasized that generally, dividend income of a foreign resident from Israeli securities is taxable in Israel at a rate of 20% or 25%, depending on the rate of participation.

Ongoing income form debentures – interest, discount fees and currency differences income, which are generated by a foreign resident from Israeli traded bonds and debentures may be tax exempt in the hands the foreign resident, subject to certain conditions, including the requirement that the foreign resident would not hold a “substantial shareholding” (10% or more).

Israeli participation exemption regime – under the ITO and subject to material conditions, an Israeli holding company may enjoy a tax exemption on dividend and capital gain derived from qualifying investments in foreign resident subsidiaries. Dividend distribution from such a company to its foreign resident shareholder is subject to a final withholding tax of 5%.

It should be noted that the above refers only to the ITO provisions and not to possible \ additional benefits under bilateral income tax treaties.

As we indicated on our Tax News Alert of August 25, 2008 the Israeli transfer pricing (“TP“) rules, which became effective on November 29, 2006 apply to cross border transactions in which one party is an Israeli tax resident.

Loans between related parties are generally subject to Section 3(j) of the ITO. Section 3(j) imposes an income tax “deemed interest” income from loans which were provided with an insufficient interest rate (index linked amount plus 4% annual interest rate): deemed interest income is allocated to the lender in an amount equal to the difference between the “sufficient” interest rate that should have applied and the interest rate which was actually adopted by the parties.

In many cases financing between related parties is performed through the use of a capital note – an unsecured loan with capital (rather then debt) characteristics and usually bearing no interest. In principle, both ITO provisions (85A and 3(j)) may apply to a capital note financing arrangement.

However, according to a recent (February 18, 2009) announcement of the ITA, that follows a previous detailed announcement(March 12, 2008) – cross border financing transactions between related parties, while using capital notes, should only be subject to the Israeli TP rules under Section 85A (and the TP Regulations) and Section 3(j) would not apply. As long as an adequate legislation is not in force or until December 31, 2009 (the earliest), such capital notes should meet the following requirements:

1. The issuance of the note was performed no later then December 31, 2008.
2. It bears no interest or indexation; and
3. In case the capital note is foreign-currency linked – the actual interest rate per annum must not exceed the exchange rate difference between the Israeli Shekel and the relevant foreign currency.

The ITA has expressly indicated its intention to initiate a legislative process in order to adopt the above also with respect to capital notes issued after December 31, 2008.

An Israeli resident company (“ILCo“) and other non-Israeli resident investors have founded a real estate fund (the “Fund”) in order to invest in real estate assets in several European countries. This Fund was formed as a Limited Liability Partnership (the “LLP”) according to the laws of a certain third country (State X). This LLP is a transparent entity for tax purposes under the laws of State X, meaning that it is not subject to tax and income or gains, as well as all the assets or liabilities of the LLP, are attributed to its partners. Any transfer of monies from the LLP to the partners is not a taxable event in State X and, accordingly, no withholding tax is imposed.  The Fund is contemplating to invest in a real estate asset located in State Y, with which Israel has concluded a tax treaty. The asset will be held through a special purpose company (SPV) that will be established under the laws of State Y for this purpose.

The Tax Decision substantiates the right of ILCo to enjoy treaty benefits, which are provided under the tax treaty between Israel and State Y (Germany), allowing it to be credited in Israel for the underlying income tax paid by the SPV in state Y, against future dividends income tax to be imposed in Israel upon distribution of dividends to the Israeli resident shareholders.

It should be mentioned that the Israeli domestic law allows an Israeli resident company to elect the “Indirect Tax Credit” method, i.e., to be credited also for the underlying corporate income tax paid by a foreign resident subsidiary, against Israeli dividend income tax, if certain minimal holding requirements are met. In the case of ILCo, these Israeli domestic law holding requirements were not met. However, under the tax treaty with Germany a minimal holding is not required in order to enjoy the Indirect Tax Credit.

Generally, according to Israeli tax law, a partnership is treated as a transparent entity and is, therefore, not taxable (its income is attributed to the partners). Nevertheless, a controversial and prominent Supreme Court decision issued in 2001 (the Sadot case) has created a certain level of ambiguity, since it referred to the disposition of an interest in a partnership as a sale of one “holding interest” / one asset – for capital gains tax purposes. According to an Income Tax Circular (14/2003) issued by the ITA following the Sadot case, the sale of interest in a partnership is also treated by the ITA as a deemed sale of a company shareholding / one asset for capital gains tax purposes.  The lack of sufficient pre-rulings in relation to partnerships left the taxpayers with this ambiguity.

As a result, the Israeli tax implications in relation to a foreign LLP within multi-national structures were unclear. This important Tax Ruling may, therefore, provide further clarity, while referring to the foreign partnership as a fully transparent entity for income tax purposes, treaties applicability and Israeli domestic tax benefits for both inbound and outbound investments structures involving foreign partnerships. For example: it may be argued that a  resident of a treaty country who invests in Israel through an LLP, which was formed under the laws of a third country (with characteristics resembling those of an Israeli partnership), may still claim the benefits according to the treaty between Israel and his state of residence (as recommended by the OECD).