The tax reform due to come into force on January 1 will lead to important, substantial change in the field of international taxation. The following is a brief sketch of the main changes in the reform that affect taxation of the international operations of companies located in Israel, as well as a number of preparatory measures that can be taken, at least in some cases.
Change in the basic taxation method in Israel
Before the reform, tax assessment in Israel was based on territory, requiring a geographic affinity to Israel on the part of the income source. On the basis of such an affinity, income produced, grown, or physically received for the first time in Israel was taxed. Various regulations were added over the years that deviated from this basis, in which certain income was regarded “as if produced in Israel”, even if actually produced elsewhere, including capital gains and income from a business controlled and operated from Israel.
Under the reform, the taxation basis was changed from territorial to personal. Residents of Israel will be taxed on their global income, regardless of where the profit was produced or received.
Rules for a controlled foreign company
The reform affects the rules for taxation of foreign corporations controlled by Israeli residents, i.e. a controlled foreign company (CFC). The goal of the transition to personal taxation was to tax all income received by residents of Israel. In order to achieve this, the legislators had to include the operations of Israeli residents through foreign companies that are not considered to be “resident in Israel,” and are consequently not subject to taxation in Israel.
A CFC is a company controlled by Israeli residents, most of the revenue and profits of which are passive, and therefore subject to a lower tax rate. Rules have now been set, under which undistributed profits originating in passive revenue of a company residing overseas, classified as a CFC, will be regarded as belonging to the Israeli residents who are the controlling shareholders in the company. The Israeli residents’ share of the profits will be deemed dividends, subject to 25% tax, and a tax deduction for foreign taxes will be granted, as stated below.
Dividends and double taxation
The reform will alter Israeli law regarding taxation of dividends, and the effect of the law on the operations of companies in countries with which Israel has signed tax treaties. Many Israeli companies conduct all their international business through a companies located in a country with which Israel has a tax treaty. One reason for this structure is that some of these tax treaties, such as the one signed with the Netherlands, include a stipulation that a dividend distributed by a holding company to the Israeli parent company will be regarded as if distributed between Israel companies.
Before the reform, this stipulation, combined with a local regulation, under which a dividend distributed between companies resident in Israel was not taxable, exempted dividends distributed from the holding to the parent company from tax, even if no taxes on the revenue from which the dividend was distributed were paid overseas.
The reform changes the local rule, by stipulating that a dividend distributed from profits produced outside Israel will be subject to taxation in Israel, even if distributed by an Israeli company. This revision in effect cancels the benefits of holding structures like the Dutch model.
Tax deductions for taxes paid in foreign countries
Until the reform, tax credits for taxes paid by Israeli companies overseas were in principle limited to withholding taxes, except for a few cases, in which Israel’s tax convention with a foreign country provided for a tax credit for corporate taxes paid by a country distributing its income.
With the extension of the base for the taxation imposed on residents of Israel, the legislators had to alter the tax credit rules for foreign taxes, in order to avoid double taxation. It was therefore stated that an Israeli company receiving a dividend from a foreign company is entitled to choose any of the following alternatives:
- 25% tax on the amount of the dividend, minus the amount of withholding tax paid in the foreign country.
- 36% tax on the revenue from which the dividend was distributed, before corporate taxes in the foreign country, minus both the foreign tax paid by the company distributing the dividend and all the withholding taxes paid. Taxes paid by the company distributing the dividend can be deducted, provided that it is only two levels down in the group structure.
Tips for taxpayers
The transition to personal taxation
One of the main effects of the transition to global taxation is on companies with cash surpluses, which have hitherto deposited them overseas to avoid Israeli taxation on the interest, since the revenue was neither produced, nor received in Israel. These companies will now have to employed complicated tax planning in order to defer or avoid Israeli taxation on this revenue.
A CFC company
The Austrian holding structure is worthy of consideration, in order to avoid paying taxes. Under Israel’s tax treaty with Austria, dividends are subject to 25% withholding tax. The rules for CFCs allow a notional credit for all taxes on deemed dividends. Since the 25% tax on dividends is the same rate as that charged in Israel, no tax need actually be paid on CFC income.
Dividends and countries with which Israel has a tax treaty
Israel’s treaty with Singapore is the only one in which the benefits were unaffected by the tax reform. Under this treaty, there is no link between the tax on dividends from a Singapore company and the tax on dividends between Israeli companies. The treaty stipulates that a dividend distributed from a Singapore company to an Israeli one is not subject to Israeli tax. As a result, the Singapore group structure confers substantially larger tax benefits, provided it can be applied.
In cases where the provisions of the treaty with the Netherlands are no longer needed, and the 5% Dutch tax constitutes an unnecessary tax burden, the Income Tax Commission has announced that the Dutch group structure can be dissolved, while an arrangement can be arrived at with the tax authorities regarding the lower taxes owed in Israel. This possibility also exists under other group structures.
Another option is to transfer the Dutch holding company to Britain, where there is no withholding tax on dividends.
Deductions for foreign taxes
In planning group structure for international business, companies established in countries with a high tax rate should be at most two levels below the Israeli company, so that the taxes paid there can be deducted in Israel.
In the structure where the foreign holding company has holdings in companies, some of which pay higher taxes and some lower, future dividends should be carefully planned. When a dividend is distributed from revenue subject to low tax rates, a dividend should also be distributed from revenue subject to high tax rates. The excess tax paid in one country can offset the payment of lower taxes from another. This can be done, as long as all the dividends are channeled through one holding company, which serves as a tax mixer.
The authors are from the tax division of PricewaterHouseCoopers-Kesselman & Kesselman.
Published by Globes [online] - www.globes.co.il - on December 23, 2002