The issue of taxes on trapped profits emerged as a result of a serious mistake made by the Ministry of Finance in 2003. Despite warnings, the finance minister at the time initiated two programs for companies to choose in the Law for the Encouragement of Capital Investment, which granted tax breaks to investors (but not to employees) in "preferred" enterprises.
The alternative program, which created the problem, established a tax postponement on a "preferred" company's profits from the "preferred enterprise": a temporary exemption until the preferred company distributes a dividend from the income made during the period when it was tax exempt. When a dividend is distributed (on which the recipient pays 15% tax), the company will pay the companies tax at a rate of 25%.
The intent of the alternative program was clear: so long as the preferred company invests its profits in enterprises in Israel, it is eligible for the tax exemption. If it does not invest its revenue in enterprises in Israel, and does not promote the objectives of the Law for the Encouragement of Capital Investment, it is not eligible for the exemption.
According to various reports, the preferred revenue has reached the astronomical amount of around NIS 100 billion. The question, should the companies be allowed to use this money for uses that contravene the intent of the tax break, is not easy. Tax planners will argue that the companies may transfer the money out of Israel, and use for investments in other countries, or lend it to their parent companies, which use the "loans" as they see fit.
I do not agree. The Israel Tax Authority should signal the companies that benefited from the tax exemption that, under the current law, any use of the money for purposes other than investment in their enterprises in Israel, will be considered as a dividend, and will be liable to 25% tax. This measure, which is not controversial, has legal grounds and is proper policy.
The legal argument: in Israel, the current intent interpretation is based on several grounds - the language grounds, i.e. does the wording of the law lend itself to a particular meaning; the subjective basis, to assess the intention of the legislature and the law's initiators; and the objective grounds, i.e. what should the correct interpretation be on the basis of the value and utilitarian ground.
Investor confidence
The linguistic grounds do not rule out the interpretation proposed here. The Income Tax Ordinance (New Version) (5721-1961) does not define what a dividend is. The Companies Law (5759-1999), which could serve as a source of inspiration for an interpretation of the term, is laconic: “dividend” - any asset given by the company to a shareholder by virtue of his right as a shareholder, whether in cash or in any other manner, including transfer otherwise than for valuable consideration, but excluding bonus shares."
The lack of space requires brevity and to propose that any transfer of money for use or benefit of shareholders can be considered as a dividend. This interpretation fits the legislative intent of the law's initiators, and there is no point to add words.
The objective value intent, which was intended to create a balance between the prevailing values and principles for economic efficiency at the Israeli company, also support this proposed interpretation. One of the prevailing cultural, value, and legal principles in Israel is the requirement of good faith. Israeli law stipulates a general duty to act in good faith in any legal matter. Avoiding the distribution of dividends and use of the money for purposes other than what is expected in order to turn a tax postponement into a total tax exemption does not comply with the obligation of good faith.
Business ethics: business ethics rules are also an important component in the objective grounding of the interpretation. It is hard for me to believe that companies with a global reputation, whose operations are based on the principles of ethics and honesty, will try to evade the duty of paying their taxes. I doubt whether they would agree to lend a hand to an unacceptable act, under which the Israeli government will legislate a retroactive law that will prevent Israel's citizens from receiving their fair share in a deal between the companies and the state. I assume that the companies will also avoid confronting the state on this point in court.
The issue of efficiency is complicated. Two rules should be borne in mind. The first states that accumulating too much capital reduces the company's return. In the free market, a company accumulates profits and invests them in so long as it is guaranteed an optimal return. When the return falls, the company will tend to divert some of its profits to its owners, and they will decide whether there is a need to invest or not. Tax breaks harm the rules of the free market and the desirable neutrality. The tax break in question here creates an inefficient incentive to accumulate profits. The Tax Authority's announcement of such a decision will solve the problem. Companies will invest their profits in Israel or will distribute them as dividends.
The second rule relates to the confidence of investors, who are liable to be surprised by the proposed interpretation. But Minister of Finance Yuval Steinitz's proposal of retroactive legislation is a worse blow to investor confidence in the government. US companies do not recognize retroactive legislation, the US constitution bans post facto legislation. Such legislation will undermine the principle of the rule of law, will harm the credibility in the government and its institutions, and will also harm our social capital.
Of the two options, making the intent of the tax break more flexible - investing the profits of preferred enterprises and postponing the tax event for a reasonable period - is far more preferable than the harm that would result from retroactive legislation. In addition, there is the important principle emerging in customary international law, which is a source of Israeli law: the principle of "single tax", which holds that any profit should be liable to a single tax, no more and no less. In my opinion, the profits of preferred companies are also subject to this law.
It should also be mentioned that the courts are frequently called upon to supplement wording when an incomplete arrangement is found in a law by analogy or in accordance with the principle of liberty, freedom, honesty, and peace of Israeli heritage. Article 77 of the Income Tax Ordinance, which allows the Tax Authority to consider accumulated profits of a small company as if they were distributed to its shareholders, can serve as a source for analogy and for the application of this article on preferred companies.
The principles of honesty and justice also require concluding that the public should be denied its fair share of the profits that companies earn from use of the human and social capital that the Israeli community offers them.
The mistaken and infuriating policy of the Tax Authority: the Tax Authority and the prosecutor are waging a long, expensive, and exhausting legal battle against ordinary citizens on all matters related to taxes on labor, including Eilat residents who received severance pay on which tax breaks were denied, Oil Refineries Ltd. (TASE:ORL) employees who received privatization grants, a lawsuit by a couple seeking separate calculations, and mothers seeking deductions for childcare. I remind tax assessors that the law considers them as a kind of legal authority and they must use their independent discretion, and not accept the dictates originating in the finance minister's caprices.
Policymakers must demonstrate more trust and confidence in the community. Companies invest in Israel because of its outstanding human capital, its strong social capital, its rule of law, certainty, research, and education. Tax considerations are less important. Investors will continue to invest in Israel, to make handsome profits, and to agree to pay their fair share of the costs of the infrastructures that make it possible for them to make profits here.
The author is a researcher and teacher of tax law and policy, fiscal legislation, and the constitutional principles of the national economy at the University of Haifa. He is the author of "Introduction to tax law" (in Hebrew).
Published by Globes [online], Israel business news - www.globes-online.com - on August 7, 2012
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