Lior Pick, Adv. (CPA (Isr.))
Lior Pick & co. Law Offices, Israel
In Cooperation with Jimmy Chotoveli
I. General Overview
The tax reform in Israel which became law on 1st January 2003 changed the tax regime from territorial taxation to personal taxation. Effectively, an Israeli resident is now taxable on his worldwide income.
The change of the tax regime required new laws to be drafted in order to prevent situations where Israeli residents could ‘transfer’ their passive income derived from overseas (e.g. interest, dividends, royalties, rent and/or capital gains) to foreign companies controlled by themselves, and thereby avoid paying tax in Israel. By ‘transferring’ passive income to foreign companies, an Israeli resident could have benefited in two ways: Firstly, not being taxed in Israel on the income of the foreign company (in specific circumstances) and secondly, being able to delay the taxation of the dividends distributed by foreign company until actually received by the tax payer (Israeli resident). In order to overcome this problem, the tax Reforms introduced regulations in Section 75(B) of the amended Income Tax Ordinance (‘the Ordinance’).
II. Section 75(B) of the Ordinance
Section 75(B) introduces the concept of ‘deemed dividend’, which is common in other jurisdictions. The purpose of ‘deemed dividend’ is taxing the controlling members of the CFC who are Israeli residents as if dividends were actually distributed to them.
Section 75(B) states that ‘if a controlled foreign company has unpaid profits, then its controlling member shall be treated as if he had received his proportional share of those profits as a dividend’.
The CFC laws therefore introduce the concept of ‘deemed dividend’ to controlling members (Israeli residents holding 10% or more of the means of control) for unpaid profits of controlled foreign companies of which 50% of the control is being held by Israeli residents. This concept effectively introduces a system of settling the payment of tax in advance. Tax will be charged if at least 50% of the company’s profits in a tax year originated from passive income generated overseas and which were taxed overseas at a tax rate not exceeding 20%. The result will be levying tax in Israel on an annual basis, for the ‘deemed dividend’ of the passive income of Israeli residents holding over 10% of the means of control in the CFC.
III. What are the characteristics of a CFC?
Section 75(B) describes a CFC as a foreign resident ‘body of persons’ for which all of the following hold true:
Example: A foreign company under control of Israeli residents has business income of $100m and passive income from dividends / interest of $100,000. Although the company makes a profit of $50,000 on its business income, it makes a profit of $75,000 on its passive income. The result will be that the CFC rules will apply on controlling members of this company who are Israeli residents (as most of its income (over 50%) is passive income).
What constitutes passive income?
Passive income is defined in Section 75(B) as each of the following kinds of income, if it is not income from business or occupation:
‘Means of control’ are defined as each of the following:
IV. CFC Tax Arrangements in Israel
Section 75(B) states that when calculating tax due by a controlling member of a CFC, a ‘deemed tax credit’ shall be granted to him in the amount that would have been deducted at source by the CFC’s jurisdiction, as if the dividend was actually distributed, but not exceeding the tax payable in Israel. Therefore, tax paid overseas ‘in excess’ will not be returned / credited in Israel. There also exist other limitations concerning the recognition of the deemed tax credit where the CFC is resident in a not reciprocating jurisdiction.
Section 75(B) states that when dividends are actually paid out by the CFC to an Israeli resident controlling member out of already taxed profits, he shall be granted a credit in the amount of the tax paid on these profits.
A controlling member selling all or some of his means of control in a CFC, shall be exempt of the tax that applies to the sale in the amount of the tax he paid in preceding tax years on unpaid profits in respect of the means of control that are being sold, and which had not been distributed as dividends until the date of the sale.
The amount of tax paid in preceding tax years shall be adjusted according to the index increase from the end of the year in which it was paid until the date of sale of the means of control.
V. CFCs: tax efficient structures?
There are several instances where the use CFCs may be beneficial. For example, until 31 December 2006, an Israeli resident can invest in foreign securities through a CFC and thereby reduce capital gains tax liability from 35% to 25% and also benefit from other advantages.
There are several situations where the CFC rules may not apply, for instance:
The tax reforms in Israel introduced new CFC laws, which inter alia attempt to prevent Israeli residents from avoiding taxes on their passive income from overseas sources by transferring the income to foreign corporations. It still remains to be seen how case law will interpret the rules of CFCs and how they will affect Israeli residents in practice.
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