Tax Alert No. 6 - 21.12.2009

After a further hearing the Supreme Court finally the Shadami rule was ratified (case 6811/04 ,dated 4/8/2009). The case that was discussed in Shadami deals with the day of purchase in combination transaction (i.e. a transaction where the property owner sells a part of his rights in the property to a contractor in exchange for building services the contractor provides him), and it has considerable importance.

As we know, a preliminary condition for tax exemption on the betterment tax when selling a residential apartment is that the seller sold all of his rights in the residential apartment (Article 49a(a)). In the most common combination transaction, only a part of the apartment is sold and nevertheless, the owner wants to get his exemption for the entire apartment. The Ben Ami ruling determined that in this case, a tax exemption would be given to the owner. Even before this ruling, the law was changed amendment no. 8, 1980), and the owner of the combination was given the opportunity to choose between waiving the exemption entirely or receiving the betterment tax exemption (taken from the total return calculated) on the entire apartment value and additional buildings rights as mentioned in article 49(g).

The Closing of such circle is made on the day the owner would sell the apartments he received in the combination transaction for the property part that remained with him. The discussion in Shadami referred to this purchase date:

The director of real estate taxation claimed that, because we are dealing with a partial sells, the part that stayed with the owner was not sold to the contractor. Therefore, when the apartments that were built on that property were sold, the day of purchase and the purchase value is the historical date of when the property was bought and accordingly the purchase date.

On the other hand, Shadmi claimed that, due to the fact that in the betterment calculation of the partial sale transaction, the betterment was calculated with  addition to the worth of the property that was not sold. Thus, the day of purchase as well as the purchase value of the apartments on that property part had to be the day of the combination. Otherwise, a double Taxation will accrue.

Shadmi’s approach was supported by six Supreme Court judges, stating that when a seller sells the apartments he got in exchange, there is no need to tax him again for the betterment referring to the rest of the property: “After applying a fiction regarding the owner, that results in betterment tax payment as if he sold the entire property to the contractor, we must continue to apply this fiction even when the apartments he got in exchange are being sold“.

In continuation with our last tax news alert (no.5), regarding the bill proposal to prevent the deductions of illegal payments as a recognized expense for tax purpose, we would like to inform that, On November 26, 2009 subsection (16) was added to article 32 of the Israeli Tax Ordinance (that deals with deductions that should not be granted), stating that: “payments, whether given in cash or money equivalent, that have reasonable basis to assume they constitute an offense under any law”.

To be clear, the tax authority should enforce this subsection only when the payment itself is illegal (such as in bribery payments), and not when there is an illegal act that is associated to the payment (for example: paying an employee that is staying in Israel illegally4 the payment in itself is legal and therefore will be deductible).

With respect to the wide discretion given to the tax assessor, in classifying certain expenses as illegal per se, we think that the implementation of such power should be much more complex. For comparison, in section 291a of the Penalty law that talks about bribery, in order to establish the bribery offence, consent from the Attorney General is required (a power that up until today was not delegated to another persona). Moreover, in order to determine whether to open an investigation in this case a decision from the head of the inquiries and intelligence department is required (after he has informed the Attorney General in his decision), whilst in our case the tax assessor is qualified to establish reasonable basis without having to get consent from a higher jurisdiction.

As we can see, this wide discretion was given to the tax assessor without any clarifications or guidelines to follow. It may lead to a result where a civil tax assessor decides on criminal matters. It is in our opinion, that that was not what the legislator was aiming for and therefore the tax assessor must proceed with much caution when dealing with this subsection.

Recently an interesting taxation resolution, referring income from a family company to a new immigrant was published (Taxation resolution 1010/09). The case dealt with a couple, residents and citizens of a treaty country that considered immigrating to Israel and getting the status of “new immigrants”. The couple owned a foreign company (fully held by them) which serves as an “agent” to another foreign company that was a related company. The couple wanted to incorporate a family company (i.e. a transparent entity for tax purpose) in Israel that will replace the “agent” company’s activities. The family company would commit to tax under Section 64 A of the Ordinance. The question was whether the couple is entitled to the benefits in accordance with Article 14 (a) of the Ordinance, even when the activity producing the income will be through the Israeli family company. Section 14 (a) of the Ordinance provides for a 10 years tax exemption on income produced outside of Israel by a new immigrant (“Olim”) or a long term returning resident, including income from business activity. Exemption is determined pursuant to Section 14 (a) and pursuant to Section 97 (b) (regarding capital gains), as applicable, and shall apply, as long as the family company’s income was produced and accrued outside of Israel. This decision is recommended from a taxation point of view, especially given that in terms of the Israeli tax system, the tax result would have been similar if the couple continued working through the foreign “agent” company they owned (that already existed or through a new company). However ,implementation of this resolution may improve the tax outcome in foreign countries where the activity takes place. It should be noted that this decision allows extensive use and creativity regarding the benefits that are given to new immigrants or a long term returning resident, combining family companies and using this taxation decision

Under the Economic Enhancement proposal for 2009-2010, which is in advanced stages of legislation, a temporary benefit provision was determined, as an incentive to withdrawal profits and enriches the country’s treasury. According to the proposal, dividends that came from distributable profits until the “determined date” (31.12.02), and would be distributed from January 1^st, 2010 until September 30, 2010 (“The Benefit Period“), will be charged at a 12% tax rate instead of a the usual tax rate of 25% (or 20% for a non-significant shareholder). This benefit will apply in practice on the distributional profits that were entitled to a 10% tax rate benefit in the event of selling the shares or dissolution of the company. In order to receive the abovementioned reduced tax rate, 4 cumulative conditions must be obtained:

1. The dividends were accepted within the benefit period– meaning, it would be recommended to delay dividend distribution, whether as an actual distribution or as part of an agreement with the tax assessor on the closure of debit balance in order to be able to realize the reduced tax rate of 12%.

2. The shares were purchased until the “determined date”-before January 1^st, 2003.

3. The dividend receiver would have been entitled to distributable profits at 10% tax rate benefit as mentioned earlier.

4. The average income from the company will not change- the shareholders income in the years 2009-2010 from salary, interest, linkage differentials or other payment from the company that distributes the dividends will not reduce from the income average received by the shareholders mentioned above in the years 2007-2008. When calculating the income for the years 2009-2012 the reduced dividend rate will not be taken into account according to this section.

This provision takes out of context many possible situations as follows:

1. 1. A company that stopped producing an active income by the end of 2008, won’t pay its shareholders any kind of salary during the years 2009-2012, and as a result, wont stand up to the income average exam.

   2. The sanction for when the income average exam is not being held is not defined as a relative sanction and so, even a 100 NIS exception from the average income may rule out a benefit for a 1,000,000 NIS dividend.

   3. The fact that one has to hold the average income during the years 2009 to 2012 can bring to uncertainty situations when claiming the benefit during these years- who can determine if the dividend divider in the year 2010 will hold the average income exam in the following years 2011 and 2012?? This provision combined with the ceiling increase in national insurance, accordingly the interest will be to decrease the wage significantly, may lead to situations in which the dividends were distributed in a 12% tax rate and after a few years the tax assessor will claim that the conditions were not held. The outcome will be as if we started of as winners (12%) but ended up losing (25% and a waste of the 10% tax rate benefit forever).

To conclude, this temporary provision is blessed in its essence but the implementation of it is not simple. It raises countless number of methods and many arguments regarding the quantification of the deserved distributable profits, when before distribution we would need to examine the dividend sum. In addition there are several steps needed to be executed already in 2009 in order to create a high standard platform for effective use of the above mentioned benefit.

We think that the legislator should reconsider the abovementioned provisions. Meanwhile, advisers should be cautious in what they advise for- the position for those who will recommend a withdrawal at 12% that may end with paying 25% and wasting the 10% tax rate benefit forever will not be easy.