Israel: Israel – On The Verge Of Dramatic Tax Reform

Israel is considered to be a part of the Western world and its legal and taxation arrangements are based on Anglo-Saxon foundations. Many people do not realize that, although its own residents bear a heavy tax burden, in certain respects, it may be referred to as a tax haven for both foreign residents and for segments of its permanent population. Probably one of the most notable characteristics of the Israeli economy over the last number of years is its globalization, evidenced in particular by the involvement of foreign investors in Israel. The government saw fit to construct an intricate system of benefits and incentives to encourage foreign residents to invest in Israel and enjoy the fruits of their initiative by way of reduced taxation. In addition, the government has adopted a number of rules easing the tax burden of immigrants.

Companies in Israel are generally subject to company tax on their profits at the rate of thirty-six percent on taxable income. Distributed profits after company tax are subject to dividend withholding tax at rates of up to 25% in the case of individual and non-resident shareholders. Interest and royalties are also generally liable to withholding tax of 25% unless reduced by a tax treaty. Lower tax rates and other benefits are applicable under Israel's investment incentive legislation.

Regarding personal taxation, Israel, in general, imposes tax on Israel source income, that is, income accruing in or derived from Israel or received in Israel from abroad (the "territorial basis"). This general principle is applicable to both resident and non-resident persons, with certain modifications in the case of residents, and subject to the provisions of any applicable tax treaty. Currently individuals are taxable at rates of up to 50%.

Israel is a party to 25 double taxation treaties. The foreign investor who takes advantage of double taxation treaties can often withdraw profits earned in Israel under favorable tax treatment. Where a taxpayer is taxable both in Israel and abroad in respect of the same income, double taxation relief may be available either in accordance with a bilateral tax treaty (convention) or, in certain cases, unilaterally. In general, double taxation relief may take the form of a credit for overseas taxes (the credit method). Many of Israel's tax treaties allow investors to take a full foreign tax credit even if the rate has been reduced in Israel as an investment incentive under the Encouragement of Capital Investments Law. This is known as "tax sparing" relief.

Alternatively, double tax relief may take the form of an exemption in the source country where income or gains arise, or in the taxpayer's country of fiscal residency (the "exemption method" of double tax relief). In all cases, reference should be made to individual treaties (where applicable) and to local legislation to ascertain the exact details of the double taxation relief afforded and the conditions attaching thereto.

On July 20, 1998, an international tax reform bill was sent to the Israeli Knesset (Parliament). The bill proposed to amend certain international tax provisions in the Income Tax Ordinance from January 1, 1999. Detailed regulations were expected on certain aspects.

The bill aims to complement the repeal of virtually all exchange control restrictions in Israel on May 14, 1998.

It was proposed to tax Israeli residents on their full worldwide income ("personal" or "residency" basis of tax) instead of the "territorial basis" mentioned above. Under the proposals, foreign residents would continue to be subject to Israeli tax on Israeli source income.

Due to a change of government in June 1999, the said bill was not enacted as a law and currently (June 2000), the above "territorial" system is the current legal situation.

The government decided to review the proposed international tax reform in preparation for a new tax reform. On May 4, 2000, extensive proposals were published in Israel by the Public Commission for the Reform of Income Tax, generally known as the Ben Basat Commission. If passed, the measures will take effect in phases starting on the above date, but principally, on January 1, 2001.

Proposed measures include a uniform rate of capital gains tax of 25% for individuals, an estate and gift tax of 10% and a move to taxation of all worldwide income for Israeli residents. In addition, incentives and stock option tax rules will be amended.

The proposals of the Ben Basat Commission have been accepted in principle by the Israeli government and the process of enactment has begun. If passed, the measure will take effect in phases starting on January 1, 2001.

Proposals of interest at the international level include the following:

• Maximum tax rate of 25% of inflation-adjusted capital gains for resident and non- resident individuals, instead of 30% to 50% at present.
• Maximum tax rate of 25% of inflation-adjusted gains from securities traded in Israel or abroad for resident and non-resident individuals (subject to tax treaties; not applicable to businesses in Israel) – instead of current exemption of 35% rate. Advisory and custody fees will be deductible, but NOT finance expenses. Securities sold may be identified specifically or if this is not possible, on a FIFO (first in first out) basis. Mutual funds will apply similar rules. Transitional rules and rules of IPO's will apply.
• In the case of homes, resident individuals will receive a life-time deduction of NIS 500,000 (US$ 125,000 approximately) but mortgage interest will not be deductible and transitional rules will apply to property acquired before the reform.
• The monthly limit on exempt home rental income will decrease from NIS 7,000 (approximately US$1,750) to NIS 3000 (approximately US$750) . Where tax applies, landlords may choose between paying full tax after deducting expenses including depreciation or tax at a rate of 10% without deductions.
• Tax of 25% for dividends received by individuals from Israeli and foreign companies, withheld at source. This is the current situation and the Commission proposed to keep it unchanged.

• Tax of 10% will be imposed on the value of estates of residents after deducting liabilities, other taxes, funeral expenses and estate administration expenses. A one-time deduction of NIS 2 million (US$500,000) will also be available unless it has been applied against lifetime gifts – see below.
• Unused portions of the NIS 2 million deduction may be utilized by the spouse of the deceased.
• Estate tax on donations to public institutions will be refunded.
• Estate tax paid will be added to the cost basis of inherited assets when calculating tax on subsequent capital gains.

• Lifetime gifts by resident individuals will also be taxable at 10% once the once-time deduction of NIS 2 million is exceeded. Gifts are reportable (and hence potentially taxable) if they exceed NIS 50,000 (US$ 12,500) per annum or if they exceed NIS 50,000 in the period between publication of the reform proposals and their enactment.
• Assets transferred to a trust swill not be treated as gifts but the value of rust assets will be added to the taxable estate. Assets transferred from a trust to any person will be treated as gifts.

• The maximum combined rate of income tax and national insurance will decrease from 59.7% to 50% in 2001.
• The lower personal tax brackets will be gradually enlarged in 2001 – 2003.

• Proposals Relating to Immigrants to Israel
• Five-year interest exemption for immigrants after the proposals are enacted.
• Continuation of 20 year interest exemption for immigrants prior to publication of the proposals.

The proposed recommendations of the Ben Basat Committee will create a major change in the economy of Israel. It will affect both Israeli taxpayers and foreign investors.

Considering the fact that income of foreign investors from time deposits of foreign exchange will remain tax free, Israel is still an attractive business arena for foreign investors. This, even more so, if we consider that Estate and Gift Tax will not apply to foreign residents.

One must bear in mind that these are only recommendations that have been accepted in principle by the government. It will be necessary to await the passing of the final bill to see which proposals have been accepted and how they will be implemented.

About the Author

Alon Kaplan, LL.M. (Jerusalem), was admitted to the Israel Bar in 1970 and was appointed a notary in 1989. He was admitted to the New York Bar in 1990 and was licensed in Germany as a Rechtsbeistand in 1991. He has been a Teaching Assistant in the Law Faculty of Tel Aviv University and presently teaches in the Law Faculty of the Herzlia Interdisciplinary College. He has published articles in journals in Israel and Germany, and is the general editor of the book "Israeli Business Law: an Essential Guide". He is also Chairman of the Israel Branch of the British-based Society of trust and estate Practitioners and a member of the International Board of Directors of the Society. Alon Kaplan wrote his Masters thesis on distributors and lectures on commercial law subjects to European business audiences. He practices law in Israel, Germany and New York.

With thanks to Leon Harris, International Partner of Ernst & Young, Tel Aviv for information on the Ben Bassat Commission.