Tax exemption for foreign financial institutions regarding interest on incoming loans
In September 2023, the Israeli parliament approved a full exemption from tax for foreign financial institutions regarding interest on loans to “preferred technological” companies. The exemption is among a cluster of new tax benefits granted under 2023 legislation to support existing – and potential – investors in Israel’s high-tech industry.
The exemption applies to:
Loans granted until the end of 2026;
Gains on a conversion discount;
Gains on linkage to the Israeli index; and
Currency exchange gains on the loan and the interest.
Instead of tax at source of 23% on interest paid to a foreign corporate lender, or 10–15% under a tax treaty, no tax will apply on these four types of income from debt financing, but only when the lending institution is a resident of a tax treaty country and when the lender or its affiliates have a presence in Israel that is in the business of providing loans.
Part of the business of the borrowing company must qualify as a “preferred technological enterprise” (as defined in Israeli tax legislation). Should the debtor be a privately owned company, then at least 5% of its shares must have been owned by residents of Israel (corporate or individual) during the year preceding the date on which the loan was granted. If a borrower is listed on a stock exchange outside Israel, then at least 5% of the shares not traded must have been owned by Israeli resident corporates or individuals at the end of the previous quarter. With regard to a borrower company listed on the Tel Aviv Stock Exchange, no detailed conditions exist.
The amount of last year’s turnover of the borrower qualifying as “technological income” should be at least ILS 30 million (approximately $8 million). The preferred company must notify the tax office of its choice to use the new exemption in the tax return of the first tax year in which interest on the loan was paid (or recognised for tax purposes). The lender must not have been a related party (less than 10% affiliation) during the previous four years and after.
The principal of the loan should amount to at least $10 million (or the equivalent in another currency) and the funds of the loan should be used for operational activities (including buying into other technological companies). The terms of the loan must have been agreed, and monies transferred, by December 31 2026.
During the loan term, employee headcount and the wages of local employees active in the technological enterprise may not undergo a substantial decrease. To prove this, the debtor’s annual tax returns must be accompanied by confirmation by an accountant (for each year during which the loan ran) confirming that all conditions were met. Interestingly, proven non-compliance with the rules can be rolled back on the Israeli corporate borrower, which will be charged the tax-not-withheld on the potentially grossed-up amount of interest paid (or interest recognised but not yet paid).
This simplification of administrative requirements regarding a reduction of withholding tax also significantly alleviates – the otherwise quite cumbersome – administrative compliance. The onerous task of obtaining withholding tax permits from the tax office for each and every interest payment should not be an issue for foreign institutional lenders.
Benefit for the acquisition of, and investment in, technology companies
A second substantial arrangement, also approved in 2023, allows for the recognition of the amount invested in shares of a local or foreign technological company, by a large preferred technological company, as an expense for five upcoming tax years.
As long as the acquired company owns a qualifying intangible asset (software, patent, etc.), the purchaser can deduct 20% of the amount of the acquisition from its "preferred technological income" (its income from R&D in Israel) each year as an expense, starting the year after the acquisition or the payment of the actual consideration (whichever is later). Without this benefit, the acquisition price of shares – as is the case in most countries – is not of any tax relevance against ongoing income.
For the benefit to kick in, the acquiring company must:
Show an average technological income in the three years preceding the acquisition of at least ILS 75 million; and
Obtain at least 80% of the means of control of the investee at a price of at least $20 million.
If the target is a foreign company, its R&D expenses must be at least ILS 20 million, or 7% of its revenue (may be waived by special permission), and its activities and intangibles must move to the acquiring company (additional, more detailed, conditions apply).
This important tax break not only offers vast financial support from the Ministry of Finance but has created the possibility, indirectly, for the investing company to recognise depreciation of the intangibles in the acquired company, in lieu of the acquired company being unable to depreciate its own intangibles.
The five-year deduction entitlement in fact creates a valuable ‘tax asset’ with the acquiring company, increasing the value of the investing company. If the parent looks to raise additional equity investments in the future, the tax asset would up its valuation.
And then, with these two combined new tax benefits, a company can, by obtaining tax-friendly financing from a foreign institutional lender, allow buying in to the five-year tax asset, when taking control of a qualifying local or foreign technology company. And the foreign lender, in turn, can collect not only the interest free from any tax in Israel but also any discount advantage on loan conversion, and currency exchange gains on credit in foreign currency.
