Over the last two decades, Israel has become known for its advanced high-tech industry, attracting significant inbound investment. The growth of the Israeli high-tech industry is partly attributable to governmental grants and tax incentives, provided through the capital incentives legislation. This legislation provides for three legal arrangements known as approved enterprise (the legal arrangement for the receipt of government grants and some tax incentives), beneficial enterprise (the legal arrangement for the receipt of tax incentives) or preferred enterprise. The latter is a legal arrangement, which was introduced as part of the 2011 reform of the capital investments incentive legislation, under which both grants and tax incentives may be received.
While having a positive impact on investment in the Israeli high-tech industry (as well as in other industries), the capital investments incentive legislation places significant limitations on repatriation of funds out of Israel. These limitations include a corporate income tax on distributed profits that were initially exempt from tax and a dividend withholding tax. The relatively high effective tax burden triggered upon distribution of such previously tax-exempt profits has led many Israeli companies to retain the exempt profits, rather than to distribute them to their Israeli or foreign shareholders.
As a result of this, the Israeli minster of finance recently introduced a temporary provision intended to encourage the immediate payment of a reduced level of corporate income tax on these retained or trapped profits (the temporary relief). This provision grants relief of 30% to 60% of the tax amount that otherwise would have been paid on distributions of trapped profits, to encourage companies to pay the (reduced) taxes during the next 12 months.
This article addresses some of the main tax considerations related to the acquisition of Israeli companies that enjoy (or enjoyed) benefits under the capital incentives legislation, in light of the recent temporary relief provisions concerning trapped profits.
Tax incentives and grants
The relevant general rules
The Israeli Tax Ordinance provides a statutory income tax rate of 25% for the 2013 tax year. An intended reduction in the rate has been postponed, and accordingly, it is expected that the corporate income tax rate will remain stable at 25% in the coming years (although there have been some informal discussions on raising the corporate income tax rate).
The Israeli Tax Ordinance also provides, in general, that dividend distributions between two Israeli companies should not be subject to corporate income tax. When an Israeli company makes a distribution to a non-Israeli company, the dividend withholding tax at the rate of 30% generally applies (however, if the recipient owns less than 10% of the right to receive profits or rights to other means of control, as defined by the ordinance, the applicable withholding tax is reduced to 25%). These rates may be reduced under most of Israel's tax treaties.
Capital investments incentive legislation up to December 31 2010 (the former legislation)
The former legislation, whose stated objective was "attracting foreign investments to Israel", provided for two incentive regimes: The approved enterprise and beneficial enterprise as discussed above. Investment grants received under the approved enterprise incentive could only be received by a company that had not opted to apply the beneficial enterprise tax incentives regime. The approved enterprises rules allowed for certain tax incentives, such as two years of tax holiday in certain cases, where the distribution of the exempt profits triggered a taxation claw-back, and a reduced dividend withholding tax of 15% that could be further reduced under treaties.
The beneficial enterprise incentives included a tax holiday and/or reduced rates of corporate income tax, depending on the percentage of foreign ownership of the company and on the geographic location within Israel of the enterprise.
Dividends out of previously exempt profits triggered tax liability under a claw-back approach. This approach provided for retroactive application of corporate income tax at a rate of 10% to 25% of previously exempt profits, based on the share of non-Israeli shareholders in the benefiting company. In addition to the retroactive corporate income tax, such distributions were subject to a dividend withholding tax of 15%, which applied regardless of the residency of the recipient company – an exception to the general rule that no corporate income tax should be levied on dividends between two Israeli companies. This withholding tax liability could potentially be reduced under the provisions of an income tax treaty. As a result, if no tax treaty relief existed, a dividend out of previously exempt earnings from exempt beneficial enterprise profits would have been subject to an effective tax rate ranging from 23.5% to 36.25%, depending on the percentage of non-Israeli shareholders. In the case of a chain of companies, a dividend-received deduction mechanism was applied. Accordingly, the tax liability was borne by the last company to receive the dividend. Therefore, subject to certain conditions, an Israeli company both receiving and distributing dividends should not bear the tax under the former legislation, but rather its shareholders will bear the withholding tax.
The new legislation commencing January 1 2011
On January 1 2011, new incentive legislation establishing a preferred enterprise came into force. The former legislation also remained applicable in parallel, in the sense that benefits under the former legislation still apply to companies that are entitled to benefits under this legislation, until the end of the period of benefits. In addition, companies that were entitled to benefits under the former legislation, or companies that commenced performing the minimal entitling investment (which was the minimal amount of investment in an enterprise required under the former legislation to qualify for beneficial enterprise status) in 2010, may elect which legislation should apply to their existing benefits plan. Thus companies may elect to apply the new legislation while waiving the remaining benefits they are entitled to under the former legislation.
For the 2013 and 2014 tax years, the applicable tax rate for a preferred enterprise located in certain areas of the country, which are designated as Development Area A, will be 7% and 12.5% elsewhere in the country. Beginning with the 2015 tax year, the applicable tax rates will fall to 6% and 12%, respectively.
In contrast to the former legislation, the new legislation provides that a preferred enterprise located in Development Area A may enjoy both governmental grants and tax incentives.
In addition, a material change introduced by this new legislation was that dividends out of the profits of a preferred enterprise should not be subject to dividend withholding tax if such distribution is between two Israeli companies. This provision has made several repatriation techniques possible and has effectively reduced the applicable Israeli tax rate in certain cases to 6% or 12%.
To motivate benefitted companies to transfer their benefits programme to the new legislation, the new legislation provides a transitional rule. Under this rule, companies that elect by June 30 2015 to waive any benefits they were entitled to receive under the former legislation will afford their Israeli corporate shareholders an additional benefit – dividends out of an approved or a beneficial enterprise's profits will not be subject to tax at the Israeli corporate shareholder level. The new legislation did not, however, resolve the issue of trapped profits. Therefore, companies remained reluctant, to some extent, to distribute profits that were generated and exempt under the former legislation. This issue has recently been addressed by the temporary relief, discussed below.
The temporary order provides partial relief from Israeli corporate income tax for companies that elect to enjoy the benefits of the temporary relief on a linear basis, that is greater distributions of trapped profits will result in increased relief from corporate income tax. According to a linear statutory formula, the effective corporate income tax rate applicable would vary from 6% to 17.5%, excluding dividend withholding tax. Regarding the dividend withholding tax, the temporary relief does not require the actual distribution of the trapped profits, merely an election to enjoy the benefits of the temporary relief, effectively a deemed distribution. Dividend withholding tax should be levied only upon an actual distribution.
Accordingly, applying the temporary relief and electing to bring the enterprise within the new legislation before June 30 2015 can lead to a situation where dividends out of approved/beneficial profits to an Israeli shareholder could be subject to tax at the rate of 6%, as opposed to 23.5% under the former legislation. In summary, the temporary relief may provide an opportunity for multinationals to consider repatriation techniques for previously exempt earnings by means of an actual or deemed distribution at a relatively low tax cost in Israel.
Main conditions for entitlement for the temporary relief
The partial relief is available for exempt retained earnings accrued before December 31 2011 provided that up to 30% (the exact rate is calculated by a statutory formula) of the released earnings are reinvested in Israel in at least one of three specified investment categories: Acquisitions of certain industrial assets used by the company (excluding buildings), research and development or salaries of newly recruited employees.
Companies that wish to apply for the temporary relief should submit their request and pay the reduced tax to the Israeli tax authorities no later than November 12 2013. The request should be made through filing a Form 969.
The tax exemption for benefited income under the former legislation generally applies until the actual distribution of exempt profits. However, anti-abuse rules deem certain transactions to be treated as dividends for the purposes of the former legislation. In case of a deemed dividend, only a claw-back taxation would apply, but not withholding tax, that would apply upon actual distribution.
A deemed dividend event, triggering taxation of previously exempt earnings, may occur as a result of a loan, or any other transfer of funds not in the ordinary course of business, from a benefited company (that is the corporation with exempt retained earnings) to its shareholder or to a company controlled by the shareholder.
The term "a company controlled by the shareholder" has been the subject of much debate. The Israeli Tax Authority has claimed in recent years that the term includes subsidiaries of the benefited company since such subsidiaries are indirectly controlled by the benefited company's shareholders. Consequently, the Israeli Tax Authority's position in recent years has been that making an investment or granting a loan by a benefited company to a subsidiary, or even acquisitions of companies, may be treated as dividend from a benefited company. Accordingly, the company would have to pay the tax from which it was initially exempt. Some of the cases involving such situations are being litigated in court.
The Israeli Tax Authority has recently hardened its position, by claiming that the purpose of the limitations on dividend distributions under the former legislation was to encourage benefited companies to reinvest their profits in their beneficial enterprises and to expand their operations within Israel. Accordingly, making an investment in or granting a loan by a benefited company to a subsidiary or acquisitions of companies by benefited companies does not fulfill the objective of the former legislation and therefore should be treated as a dividend from the benefited company.
The Tax Authority's new position regarding investment in subsidiaries seems to stand in contrast to positions generally taken by Israeli tax practitioners and even historical positions of the Israeli Tax Authority itself, where a dividend is typically a distribution of profits up the chain, rather than investment down the chain.
The provision regarding temporary relief has enacted the Israeli Tax Authority's position within prime legislation, albeit indirectly, since it provides that the benefit would apply to exempt income that should not have been subject to tax until the application of the relief, if no triggering event has occurred, but excluding certain types of investments in a subsidiary, including granting loans to a subsidiary and acquisition of companies from third parties. In other words, the temporary relief will apply only to tax that should not have been paid yet. It will not apply to income that was previously distributed as dividend or to income that was distributed through events that are deemed dividends – excluding deemed dividend events that were triggered from investment in a subsidiary, a loan to a subsidiary, or acquisition of company. The actual meaning of such provision is that these types of investments in a subsidiary are now considered triggering events for the purposes of the former legislation. One may argue that this is a retroactive change in the law that, generally speaking, is unlawful and therefore may be invalid. However, such argument should still be analysed from a legal perspective.
In addition to the cash tax considerations outlined above, the Israeli Tax Authority's apparent change in position raises concerns that may have financial statement implications. If, before the enactment of the temporary relief, benefited companies took the position that investments and loans – down the chain – should not have been treated as dividends that trigger tax implications and therefore did not record liabilities related to the uncertainty of the tax position with respect to such investments, following enactment of the temporary relief companies should consider whether or not their tax provision needs to be updated. As to whether or not companies need to make a provision in relation to their past positions, companies that are about to perform either large distributions or large investments (or loans) in subsidiaries, with accompanying changes to their tax provisions, should consider applying the temporary relief, as it is expected to reduce their tax costs.
Maximisation of tax incentives and grants
We urge all companies to analyse their position under each of these provisions to ensure that they maximise the benefits from the potential tax incentives offered by the Israel Tax Authority.
The most pressing planning consideration that companies should immediately address relates to commencement of the benefits period under the new legislation. In general, companies enjoying the Israeli tax exemption should enjoy greater benefits by electing to postpone the application of the new legislation, while maximising incentives under the former legislation. However, the examination of how and when companies should elect to apply the new legislation should be made on a case-by-case basis, as it depends on each company's entitlement to specific tax incentives.
Another consideration that should be taken into account is the company's intention to distribute profits, and whether such distribution would be to Israeli shareholders or to non-Israeli shareholders. This should be analysed based on the temporary relief.
We recommend that companies with trapped profits to consider applying the temporary relief and make all necessary procedures regarding the application of the Temporary Relief no later than November 12 2013.
With specific regard to M&A activity, including in the context of corporate acquisitions, the new legislation potentially allows for simplified structuring for profit repatriation and reduced effective rates of tax on such profits compared to the previous tax regime. This will need to be analysed on a case by case basis (for example whether the group structure includes more than one Israeli company, which incentive legislation applies to its enterprise).
Finally, we recommend benefited companies which took the position that investments and loans – down the chain – should not be treated as dividends which trigger tax implications and therefore did not record liabilities related to the uncertainty of the tax position with respect to such investments, should consider whether or not their tax provision needs to be updated.
The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global Ernst & Young organisation or its member firms.
Partner, international tax services|
Ernst & Young
Tel: +972 3 6232534
Yaron Kafri has been an international tax partner at Ernst & Young Israel since 2005. In the context of his work at Ernst & Young, he served as head of the Israeli international tax desk at the New York office for two years.
Before joining the firm, Yaron served as a tax inspector at the Israeli Tax Authority and focused on banking and other financial institutions, stock markets, investment and holding companies.
Yaron has vast experience in assisting and consulting to foreign investments by Israeli companies as well as foreign investments in Israel. Most of his clients are prominent multinational Israeli corporations in real estate, high-tech and industries that invest abroad, as well as multinational foreign corporations that operate in Israel.
Senior manager, international tax services
Ernst & Young Israel
Tel: +972 3 6232 742
Doron Mutai is a senior manager at the international tax services department of Ernst & Young Israel. Doron joined Ernst & Young in 2004, after he practiced law at the district attorney of Tel-Aviv (tax and economics). Doron has vast experience in assisting and consulting to both inbound and outbound investments. He advises on a day-to-day basis to multinationals from various industries, including high-tech industry financial and insurance industry, telecommunications, real estate investments and private equity funds.
Doron has been involved in some of the largest acquisitions of Israeli companies and often advises clients regarding planning the acquisition, structuring, and post merger integration.
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